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Vera C. Smith, The Rationale of CentralBanking and the Free BankingAlternative [1936]

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Edition Used:

The Rationale of Central Banking and the Free Banking Alternative,Foreword by Leland Yeager (Indianapolis: Liberty Fund, 1990).

Author: Vera C. SmithForeword: Leland B. Yeager

About This Title:

Written as a doctoral dissertation under Friedrich Hayek at theLondon School of Economics in the early 1930s, the book coversthe history of free banking in the 19th century and reviews thetheoretical arguments both for and against the idea of freebanking.



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Table Of Contents

PrefacePublisher’s NoteForeword [to the Original Edition]The Rationale of Central BankingChapter I: IntroductionChapter II: The Development of Central Banking In EnglandChapter III: The Scottish SystemChapter IV: The Development of Central Banking In FranceChapter V: The Organisation of Banking In America:

Decentralisation Without FreedomChapter VI: The Development of Central Banking In Germany

1Chapter VII: Discussions On the Theory of the Subject In

England and America Prior to 1848Chapter VIII: The Discussions In France and BelgiumChapter IX: The Discussions In GermanyChapter X: The Post-1848 Discussions In EnglandChapter XI: Discussions In America Prior to the Foundation of

the Federal Reserve SystemChapter XII: The Arguments In Favour of Central Banking

ReconsideredAppendix: On the Working of the “automatic Mechanism” of

Credit Control1.: The Note–issuing Case2.: The Deposit Credit Case



[Back to Table of Contents]

Prefaceby Leland B. Yeager

Vera Smith’s The Rationale of Central Banking invites us toreassess our monetary institutions and give reform proposals dueconsideration. The decades since it first appeared in 1936 haverestored its themes to relevance. Government-dominated monetarysystems have continued to perform poorly. Other experience, aswell as the work of James Buchanan and the Public Choice School,has heightened skepticism about government generally. People arenow willing to discuss what Vera Smith set out to examine: “therelative merits of a centralized monopolistic banking system and asystem of competitive banks all possessing equal rights to trade”(p. 3).

After a biographical sketch of Vera Smith, I survey the leadingthemes of her book. I then offer some embroidery on them andconsider how they bear on current issues of money and bankingreform.

Vera Smith wrote The Rationale of Central Banking as a doctoraldissertation at the University of London School of Economics underthe supervision of Friedrich A. Hayek. She received her Ph.D.degree there in 1935, having enrolled as an undergraduate in 1930.She studied with Hayek, Lionel Robbins, T. E. Gregory, J. R. Hicks,and Dennis Robertson; in 1933-34 she was Hugh Dalton’s researchassistant. Thanks not only to the school’s faculty but also to a groupof students who, like herself, were to become renownedeconomists, Smith experienced the London School in what wereperhaps its golden years. In 1936-37 Smith served as economicassistant at the Imperial Economic Committee.

In April 1937, Smith married the German economist Friedrich Lutz,who was an assistant to Walter Eucken in Freiburg and had held afellowship of the Rockefeller Foundation in England in 1934-35. Inthe year of their marriage Friedrich Lutz received anotherRockefeller fellowship, and the couple traveled to the UnitedStates. After a year and a half back in Europe, the Lutzes returnedto the United States just before the outbreak of World War II.(Lutz’s traditional-liberal orientation blocked him from an academiccareer in Nazi Germany.) During the war Vera Lutz served on theresearch staffs first of the International Finance Section ofPrinceton University and then of the League of Nations, also inPrinceton. In the latter post Vera Lutz worked with such noted



economists as Alexander Loveday, Gottfried Haberler, and RagnarNurkse.

From 1939 to 1953 Friedrich Lutz held positions from instructor tofull professor at Princeton University. After a year in 1951-52 asvisiting professor at Freiburg, in 1953 he moved to the Universityof Zurich, where he taught until retiring in 1972. He was a visitingprofessor at Yale in the winter of 1962-63. From 1950 to 1963 Mrs.Lutz spent frequent periods for research at the Bank of Italy, thedevelopment agency for southern Italy, and the Banca Nationale delLavoro. From 1963 to 1969 she frequently visited Paris for researchon French indicative planning. She never chose to accept ateaching position. Professor Lutz died in Zurich in 1975; Mrs. Lutz,born at Faversham, Kent, England, on 28 April 1912, died in Zurichon 20 August 1976.1

Vera and Friedrich Lutz were both prominent members of the MontPelerin Society, and Friedrich was its president from 1964 to 1967.The Society’s international membership consists mainly of scholarsbut includes journalists and business people also. It wasestablished under the leadership of F. A. Hayek in 1947 with thepurpose of fighting socialism and revitalizing classical liberalism.

The Lutzes collaborated on several works, including Monetary andForeign Exchange Policy in Italy (1950) and The Theory ofInvestment of the Firm (1951). Books written by Mrs. Lutz aloneinclude Italy, a Study in Economic Development (1962) and CentralPlanning for the Market Economy: An Analysis of the FrenchTheory and Experience (1969). Besides writing many articles onmoney, credit, banking, public finance, the theory of the firm,economic development, economic planning, and the labor market,Mrs. Lutz translated books by Wilhelm Röpke, Oskar Morgenstern,and Fritz Machlup from German into English.

A central bank, as Smith notes, is not a product of naturaldevelopment. It originates through government favors and bearsspecial privileges and responsibilities. Typically, it serves as bankerfor the government and for the ordinary banks and monopolizes ordominates the issue of paper money. From this privilege derive thesecondary functions and characteristics of a modern central bank:it guards the bulk of its country’s gold reserve, and its notes anddeposits form a large portion of the cash reserves of ordinarybanks. It is constrained under a gold standard, though less tightlythan competing banks would be, by the obligation to keep its notesredeemable. When unable to meet this obligation, it typicallysuspends payments and goes off the gold standard, while its notesacquire forced currency. (One excuse for such actions is thatreserves held with it can be guaranteed safe only if its notes remain



in circulation even with their redemption suspended.) Control overthe volume of its own note and deposit issue gives the central bankpower over the size or scale of the country’s money and bankingsystem and over the general credit situation.

Smith touches on the aims and origins of central banks. A centralbank may originate as a privately owned profit-seeking institution.Another motivation, not incompatible with the first, is to help in thefinancing of government. Smith reminds us of that reason forestablishment of the Bank of England, and she shows similarmotivations at work in France and elsewhere.

The special privileges and dominant position of a central bankthrust responsibilities onto it that dilute or override its profitorientation. This is true of fully evolved central banks like today’sBank of England and the Federal Reserve System in the UnitedStates. As “lender of last resort,” the central bank is supposed tocome to the rescue of the ordinary banks during shortages ofreserve funds and scramblings for currency, lending them its ownfreshly issued bank notes. Disregarding narrow profitconsiderations, it is supposed to use its influence over money,credit, and interest rates to serve public objectives such as, before1914, keeping the country’s currency firmly on the gold standardand, nowadays, resisting inflation while promoting production andemployment (to the extent that those objectives are feasible andcompatible).

Free banking, as Smith defines it, is a regime allowing banks tooperate and even to issue bank notes under no restrictions beyondcompliance with general company law (pp. 169-170). A bank mayenter the field without special permission if it can show profitprospects, raise sufficient capital, and win public confidence initself and its notes. It has the same rights and responsibilities asother business enterprises. Its notes are “promises to pay,”redeemable in whatever the basic money might be (under the goldstandard, this is gold or instruments redeemable at full value ingold). As Smith points out, “A general abandonment of the goldstandard is inconceivable under these conditions” (p. 170). No bankcould keep irredeemable notes in circulation by having themdeclared legal tender. Any bank suspending redemption would bedeclared bankrupt and liquidated, its assets being applied to meetthe claims of its creditors. Stockholders would lose all or part oftheir investment.

Smith reviews the banking histories of England, Scotland, France,Germany, and the United States. She also surveys controversies inthese countries, mainly in the nineteenth century, over whether acentral bank with its distinctive responsibilities and powers is



desirable or, on the contrary, private banks might advantageouslybe left free of central domination. (She sets aside, as she notes, areview of Italian and Spanish writings.) She reviews by countriesrather than by topics, presumably finding it convenient to grouptogether the arguments of writers who were largely commenting oneach other’s writings.

Smith cross-groups writers into four camps (as in her table on page144-145) according to their acceptance of the doctrines of eitherthe currency school or the banking school and their advocacy ofeither central banking or free banking. The first two schools aremainly associated with British monetary debates from the 1820son.2 The currency school accepted the quantity theory of moneyand generally wanted to make a mixed system of gold and papercurrency behave much as pure gold money would have done. Thebanking school accepted doctrines tinged with fallacy, doctrinesabout “real bills,” about accommodating the quantity of money,even over the business cycle, to changes in the supposed needs oftrade, and about a supposed automatic reflux of excessive banknotes.

The controversy over free versus central banking is distinct, saysSmith (pp. 171-172, 176): it raises arguments additional to andindependent of the points disputed by the banking and currencyschools. Both Lawrence White (1984) and Anna Schwartz (1987)have since collapsed Smith’s four categories into three: the free-banking school, the currency school, and the banking school.Perhaps the explanation is that White and Schwartz dealt almostexclusively with British controversies, whereas Smith extended herstudy to the continent. Few writers seem to have adhered to thecurrency and free-banking schools both, but Smith did find at leastthe Germans Otto Michaelis and Otto Huebner, the AustrianLudwig von Mises, and the Frenchman Henri Cernuschi in thatposition. As she says (p. 176), theirs could be a perfectly consistentposition so far as they aimed at checking fluctuations in the volumeof money and credit.

Historically, support for central banking was more closelyconnected with the currency than with the banking school, and thecurrency school’s success in theoretical controversy was claimed asa victory for central banking as well. The free-banking school cameunder suspicion, especially in France, for placing so muchemphasis on banking-school ideas, even inflationary ideas,including the denial of the quantity theory and claims that banknotes cannot be issued in excess provided that they are issued byway of loans of appropriate kinds (p. 172).



The banking school placed ill-conceived emphasis on bankableassets. Smith repeatedly uses the German term bankmässigeDeckung, evidently regarding it as untranslatable. Literally, itmeans “bankwise cover” and refers to the idea that a bank’smonetary liabilities should be matched by holdings of suitableassets. These, according to the notorious “real-bills doctrine,” werequintessentially short-term, self-liquidating commercial andindustrial loans, loans to finance the production or marketing ofadditional goods within a very few months. Banking conducted onsuch a principle would properly match the money supply to thesupply of goods coming to market. Besides overlooking the fallacyof composition involved, the banking school ignored the point thatnot even a merely short-term general overissue of bank notes canbe quickly remedied without disturbing business conditions. It wasjust such disturbances that the currency school aimed atpreventing (pp. 173-174).

The supposed principles of bankable assets and especially ofautomatic reflux of excessive notes might have a certain validityapplied to a free-banking system, but they would not apply to acentralized system. The difference involves competing banks’demands for settlement of claims on each other and the restraintposed by adverse clearing balances (p. 174 and later in chapterXII). In practice, a centralized fiduciary note issue constrained by afixed limit and a decentralized system with gold convertibilitywould not differ greatly in their results.

Smith interprets Walter Bagehot as adopting a compromise view (p.143). He found Britain’s banking system anomalous—not whatpeople would have deliberately designed from scratch. But itexisted, and Britons had to make the best of it by clearlyrecognizing its weaknesses and having the Bank of England acceptits attendant responsibilities and hold reserves adequate formeeting them.

In her concluding chapter especially Smith reconsiders the mainarguments on central banking versus free banking. Thisreconsideration was necessary, for “the superiority of centralbanking over the alternative system became a dogma which neveragain came up for discussion and was accepted without question orcomment in all the later foundations of central banks” (p. 167). Foranswers to most of these arguments, the reader should see Smith’sown discussion.

One argument against free banking is that the notes of a particularbank do not remain in the hands of the persons who dealt with itvoluntarily, as by borrowing from it. Routine circulation thruststhem even onto persons scarcely in a position to discriminate



between good and bad notes. The government should thereforeimpose some uniformity onto the note issue (p. 177).

A second argument concerns monetary expansions andcontractions, leading to inflations and depressions. “Any attempt tomake a final evaluation of the relative merits of alternative systemsof banking must look primarily to the tendencies they manifesttowards instability, or more particularly to the amount of causalinfluence they exert in cyclical fluctuations” (p. 192). Opponents offree banking (such as Mountifort Longfield, discussed below)argued that aggressively expanding banks might impose theburden of restraint, or even the necessity of going out of business,onto more conservative banks (pp. 85-88, 177-178).

A third argument holds a central bank better able than competingbanks to command public confidence and to cope with crises, as byserving as lender of last resort (pp. 185ff). A fourth argument findsa central authority necessary for a “rational” monetary policy (pp.189-190); a fifth regards central banks as essential to internationalmonetary cooperation (p. 190).

These last two arguments had become in Smith’s time “the almostexclusively motivating reasons for the foundations of new centralbanks” (p. 192). Modern thinking tended to favor “intelligentplanning” over automatic rules. A related argument presumably atwork, as in the establishment of the Federal Reserve System in theUnited States, is one Smith does not state explicitly: othercountries already have central banks. Why remain backward or outof step? Nowadays, furthermore, it seems reasonable to supposethat central banks are valued for providing prestigious andcomfortable jobs.

Before turning to specific issues of monetary reform, let us ponderwhat Smith calls “by far the most important controversial point inthe theory of free banking” (p. 88; cf. pp. 85-88, 177-185, 197-199).She attributes the Controversy to Mountifort Longfield, who, in anarticle of February 1840, imagined a system of two banks initiallydoing the same volume of business and holding equal goldreserves. Now one bank aggressively expands its loans and noteissue. Later on, as the public starts demanding gold, let us say forexport after the monetary expansion and resulting price inflationhas caused a balance-of-payments deficit, the public will notselectively present the notes of the guilty bank for redemption. Thisdemand falls, rather, on both banks. As a result, the gold reserve ofthe bank that did not increase its note circulation falls in greaterproportion than its circulation. If this moderate bank wishes torestore its original reserve ratio, it must shrink its volume ofbusiness, which, however, enables its aggressive rival to expand



even further. The moderate bank may be driven out of businessaltogether, unless it too expands aggressively in self-defense.

To generalize: a country with several or many note-issuing bankswill suffer under alternations of business excitement anddepression, of high and low prices. A bank will gain most byexpanding during the period of excitement and being quick tocontract as the panic arrives. A system more injurious to a countrys prosperity could scarcely be devised.

Smith examines this argument in her concluding chapter; somerestatement and interpretation may be in order here. One flaw inLongfield’s argument, she says, is that it overlooks how continuousexpansion by one group of banks and contraction by the moderategroup will cause an increasing proportion of the gold outflow toimpinge on the expanding banks’ reserves, which will be exhaustedbefore the moderate banks have been driven out of business.

A relatively minor flaw in Longfield’s argument was his stress onthe return flow to an expanding bank of its own and other banks’notes as its borrowing customers repay their loans. That strand ofthe argument neglected the lag between the granting and therepayment of loans, an interval during which increasing amounts ofthe expanding bank’s notes would nevertheless be presented forsettlement at the clearinghouse.

Furthermore, Longfield’s argument considers only the public’sdemand for redemption of notes. It overlooks the incentive eachbank has to demand redemption of other banks’ notes as it receivesthem from depositors or from borrowers repaying loans. In acompetitive system, no bank will pay out the notes of rival banksover its own counter. It will return them to their issuers throughthe clearing process. If one bank expands Out of step with the rest,balances at the clearinghouse will go against it, and it will lose goldpaid to its rivals in settlement. This mechanism would work at anearlier stage than the external drain of gold; the bank would beginto suffer reserve drain almost immediately (a point stressed byLawrence White and George Selgin, cited below). This effect comesin addition to the immediate arithmetical reduction in the ratio ofreserves to the bank’s expanded note issue.

Smith’s discussion brings to mind one distinction between twokinds of money, bank notes and checking accounts. Passively and atleast temporarily, the ordinary transactions of a member of thepublic will thrust onto him notes issued by banks besides his own.The same is not true of checking accounts. He will promptlydeposit or cash any checks received, which will quickly be routedfor payment to the banks they are drawn on.



If money consisted exclusively of checking accounts (with goldbullion, perhaps, serving as the reserve and redemption medium)and if all payments were made by check, the clearing processwould operate in the tightest conceivable way. Unlike some portionof bank notes, substantially all checks would be promptly presentedfor settlement; and any bank expanding its business out of stepwith the demand for deposits in it would be promptly punished andrestrained by adverse clearing balances.

The coexistence of bank notes with bank accounts, then, somewhatdilutes or delays the discipline of the clearing process. Not all notesreturn quickly to their issuers for redemption. Surely, though, notesrelax the discipline only slightly. In an economy with free bankingbut operating in other respects as it does today, most money wouldcontinue to consist of checking accounts. Retail merchants wouldcontinue routinely depositing their cash receipts in their ownparticular banks, each of which would have an incentive to sendnotes of other banks through the clearing process.

One of the leading issues of monetary assessment and reformconcerns the monetary standard. This was clearly implicit inSmith’s work and has in recent years been the major starting pointfor the revival of interest in the question of free banking.

Many questions suggest themselves: How should the money unit bedefined? Should the dollar be defined in gold, with all other kindsof money directly or indirectly redeemable in gold? Should the unitbe the dollar of government fiat money, with the money supplymanaged by the central bank under instructions to keep the pricelevel stable? Similarly, what should the base or dominant moneybe—the kind of money in which other kinds are denominated andultimately redeemable? (Federal Reserve notes fill this role in theUnited States nowadays.) Is it necessary to have any base money atall—and any central bank to issue and manage it?

Nobel laureate F. A. Hayek (1976, 1978, 1984) has proposedauthorizing the issue of competing private currencies. Ideas linkedwith his supervision of Smith’s dissertation presumably haveinfluenced him. Books by Lawrence White (1984) and GeorgeSelgin (1988) survey the history and theory of free banking andpropose freedom of banks to issue notes as well as deposits, whichwould probably be denominated and redeemable either in gold orin government base money, whose amount would have been frozen.The seventh annual monetary conference of the Cato Institute, heldin Washington, D.C., in February 1989, was devoted almost entirelyto ideas for radical monetary reform along private-enterprise lines;and a book of papers from earlier conferences (Dorn and Schwartz1987) contains much discussion of similar themes.



An idea that seems promising to Robert Greenfield and me (1983,1989) would bar the government from issuing money or exertingany special control over the money and banking system. But thegovernment might define a new unit of account in which prices arequoted, contracts written, accounts kept, and so forth, to replacetoday’s unsatisfactory unit, which is the dollar bill of governmentfiat money. The government would promote the new unit byemploying it in its own operations. The unit might be defined by aspecific quantity of gold. Because of gold’s probable instability invalue, however, a unit defined by some comprehensive bundle ofgoods and services would possess a more nearly stable purchasingpower over goods and services in general.

With the government barred from money issue, banks would befree to issue notes and deposits denominated in this new unit. Eachbank, faced with competition, would have to keep its notes anddeposits redeemable. Redemption would probably take place not inthe actual goods and services defining the unit but indirectlyinstead, in equal-valued amounts of some convenient medium,possibly gold but probably designated securities. Routine interbanksettlements at the clearinghouse, as well as arbitrage, wouldquickly reverse incipient deviations of the price level from whatcorresponded to the unit’s commodity-bundle definition. Theordinary member of the public would need to understand thesystem’s details no more than he needs currently to understandFederal Reserve operations.

Far from involving the textbook inconveniences of barter, theproposed system would feature a well-defined unit of account.Freed from the restraints that nowadays seem necessary tomaintain, more or less, the value of the government fiat dollar,financial innovation would flourish, bringing a payments systemmore convenient than the one we know today. Market forces wouldmake the quantity of money accommodate itself to the demand formoney at the stable price level corresponding to the unit’sdefinition. This self-regulation of the money supply would bringdecisive advantages in macroeconomic performance.

Here is not the place for a full analysis of these issues. My point isthat academic discussion of radical, private enterprise-orientedmonetary ideas has become respectable again. Public discussionand political feasibility may follow in time. Vera Smith’s scholarlyreview and judicious assessments of the experience and theory thatbear on the issues of free banking and central banking should playa prominent role in the ongoing discussions.

Leland B. YeagerLudwig von Mises Distinguished Professor of Economics



Auburn University

ReferencesDorn, James A., and Anna J. Schwartz, editors, The Search forStable Money, University of Chicago Press, Chicago, 1987.

Ente per gli Studi Monetari, Bancari e Finanziari “Luigi Einaudi,”Moneta, Dualismo e Pianificazione nel Pensiero di Vera c. Lutz,Società Editrice il Mulino, Bologna, 1984.

Greenfield, Robert L., and Leland B. Yeager, “A Laissez-FaireApproach to Monetary Stability,” Journal of Money, Credit, andBanking, 15:302-315, August 1983.

Gusman, Rosaria Giuliani, “Note Bio-bibliografiche (1912- 1976),”in Ente... Einaudi, 1984, pp. 89-110.

Haberler, Gottfried, “Vera e Friedrich Lutz. Una famosa coppia dieconomisti dei nostri tempi,” in Ente... Einaudi, 1984, pp. 47-53.

Hayek, Friedrich A., Choice in Currency, Institute of EconomicAffairs, Occasional Paper 48, London, 1976.

Hayek, Friedrich A., Denationalisation of Money, 2d ed., Institute ofEconomic Affairs, London, 1978.

Hayek, Friedrich A., “The Future Monetary Unit of Value,” in BarryN. Siegel, editor, Money in Crisis, Pacific Institute for Public PolicyResearch, San Francisco, and Ballinger Publishing Company,Cambridge, Mass., 1984.

Schwartz, Anna J., “Banking School, Currency School, Free BankingSchool,” The New Palgrave, A Dictionary of Economics, StocktonPress, New York, 1987, vol. 1, pp. 182- 185.

Selgin, George, The Theory of Free Banking, Rowman & Littlefield,Totowa, N.J., 1988.

Veit-Bachmann, Verena, “Friedrich August Lutz,” Neue DeutscheBiographie, 1987, vol. 15, pp. 565-567.

White, Lawrence H., Free Banking in Britain, Cambridge UniversityPress, New York, 1984.

Yeager, Leland B., and Robert L. Greenfield, “Can MonetaryDisequilibrium Be Eliminated?” Cato Journal, 9, Fall 1989.




Publisher’s NoteThe publisher would like to thank Mrs. Brenda K. Fowler and Mr. A.Wilson-Smith for their help in bringing their sister’s book back intoprint. Their assistance has been invaluable.

The Rationale of Central Banking was originally published in 1936by P. S. King and Son in London. We have added the subtitle andthe Free Banking Alternative to more adequately reflect thebreadth and spirit of the work.

For this LibertyPress edition, we have newly set the type. Obviousspelling errors have been silently corrected. Footnotes are nownumbered consecutively within each chapter. Otherwise, the textand the footnotes have been retained and styled as they were in theoriginal. The bibliography, however, has been significantlyenhanced. Citations in the original edition included only last name,title, and year. We have provided full bibliographic information. Fortheir assistance in providing this information on American, English,French, German, and Italian titles, we would like to thank thefollowing scholars: Professor Lawrence White of the University ofGeorgia, Professor Philippe Nataf of the University of Paris, and Dr.Reinhold Veit and Mrs. Wendula v. Klinckowstroem of the WalterEucken Institut. A new, full index has been prepared for thisedition.




Foreword

[To The Original Edition]This essay is a study of the historical and analytical bases of thedevelopment of Central Banking, the reasons why the note issuewas made the exception to the general application of laissez-faireprinciples, and why Central Banking was adopted in preference to“Free Banking” with Competition in the note issue.

It has been submitted and approved as a thesis for the Degree ofDoctor of Philosophy in the University of London.

My grateful thanks are due to Professor F. A. von Hayek, who firstsuggested the topic as a subject worthy of research and gave mevaluable advice on many occasions. I should like also toacknowledge the assistance given me by the British Library ofPolitical and Economic Science in obtaining some of the less easilyaccessible material.

Vera C. Smith

LondonOctober 1935




THE RATIONALE OF CENTRAL BANKING

CHAPTER I

IntroductionIn the present century centralised banking systems have come tobe regarded as the usual concomitant, if not one of the conditionsof the attainment of an advanced stage of economic development.The belief in the desirability of central bank organisation isuniversal. Recently also there have been attempts to widen the unitof control in the movement towards international bankinginstitutions and international co-operation between the alreadyexisting central banks of the separate countries. There is, however,a noticeable lack of any systematic examination of the bases of thealleged superiority of centralised banking over its alternative.

Practically all the discussion on the relative merits of a centralisedmonopolistic banking system and a system of competitive banks allpossessing equal rights to trade, took place in a period of someforty to fifty years in the nineteenth century, since when it hasnever been reopened. In that period, however, the subject was oneof the most keenly debated of its time. This is especially true ofFrance, and indeed the period of about twenty years during whichFrench thinkers occupied themselves with this problem is perhapsthe most productive of any in French economic literature, bothfrom the point of view of Output and from the standpoint of itsquality in comparison with that of other countries in the sameyears.

In the twentieth century most countries have finally decided infavour of a central banking system, but in the nineteenth century(at least up to 1875), again, most especially on the Continent and inthe United States—in England the system as it stood after thepassage of the Bank Act of 1844 was not seriously challenged afterthat date—it was still a matter of dispute as to what sort of formthe banking system should take. It is notable that when laisser-fairetheories and politics were at their height so far as other industrieswere concerned, banking was already regarded as in anothercategory. Even the most doctrinaire free-traders, with the possibleexception of Courcelle-Seneuil in France, were unwilling to applytheir principles to the business of banking. It was widely contendedthat banking must be the subject of some special regulations,although what precise form these regulations should take remainedan open question for several decades.



Very little attention has been paid in modern economic literature tothe consideration of the rationale of the particular system ofbanking that we have succeeded in evolving, in the light of theprogress that has been made in economic science since the timewhen the problem was in the forefront of discussion.1 The actualdiscussion which did take place is, moreover, one of thecontroversies among our forefathers with which this generation,more especially in England, is surprisingly unfamiliar. Neither dowe find that the authorities responsible for introducing centralbanks into countries previously without them have any clear idea ofthe benefits to be obtained therefrom.

It is the purpose of this essay to investigate the motives that havein the past led to the establishment of central banks and to discoverthe theoretical foundations underlying such motives. Anexamination of the reasons for the eventual decision in favour of acentral banking as opposed to a free banking system reveals inmost countries a combination of political motives and historicalaccident which played a much more important part than any well-considered economic principle.

The exact significance to be attached to the terms “free banking”and “central banking” will become clear in the course of theargument, but for the present we shall summarise the problem inthe following questions: Is it preferable that the note issue shouldbe in the hands of one single bank, or at any rate a definitelylimited number of banks specially authorised to undertake it, andamong which one bank holds a position of sufficient predominanceover the rest as to be able to exercise some control over them, or isit preferable that there should be as many banks of issue as find itprofitable to enter the note-issuing business? Further, if this latteralternative is affirmed and plurality is allowed, is it necessary toimpose special requirements, such as a prior lien on assets or thedeposit of bonds, to protect note-holders from the consequences ofbank failures? Secondly, even if the issue of notes is restricted to asingle bank, should there not be freedom for the foundation ofbanks of deposit exercising no rights of issue? The question may beput still more generally: Is it necessary in the interests of soundbanking and a stable currency to impose special restrictions, otherthan those imposed on all business corporations under thecompany law, firstly, on banks issuing notes, and, secondly, evenproviding the answer to this is in the affirmative, on banks ofdeposit which issue no notes?

This was the historical approach to the question as it presenteditself to the writers of last century. The place of primary importancewas given to the first problem of the note issue, and it is to this thatwe shall devote most attention. Our plan will be first to sketch the



decisive events, relevant to our main topic, in the history ofbanking and credit in the leading countries, and then to examinethe arguments of both sides in the theoretical controversy.

So far as English banking is concerned, the broad outlines werequite clearly drawn at a comparatively early date, and the system,once established, was never very seriously threatened. Scotland isof particular interest, because the Scotch system was quoted bypractically every member of the free-banking school as theconclusive example of the remarkably successful functioning of thesystem they advocated. The United States of America were likewisecited by the protagonists of the central banking school as theclearest disproof of the practicability of any such system. Francewas rather later than England in finally and irrevocably adopting acentralised banking system. Germany went through a series ofmoves and countermoves before at last deciding in favour of thesame plan in 1875, but here it rather distorts the discussion toconsider Germany as a whole, and it is more appropriate toconsider the separate States, since Germany did not form a unit till1871. The theoretical discussion of the subject was practicallyclosed by 1875, by which time the question of the standard hadcome to assume a far greater importance, but in America severalpoints of interest were raised some years later in the debatespreliminary to the establishment of the Federal Reserve System.

In our study of the chronological development of the bankingsystems of England, Scotland, France, the United States andGermany, our main emphasis will be concentrated on those facts,firstly, which mark the choice at various stages between monopolyand Competition, and, secondly, which refer to other aspects ofGovernment management and interference in banking in general.

The chief interest of any theoretical treatment of the place of thebanking system in the general economy lies in the part it may beassumed to play in the causation of the phenomena of booms anddepressions. We shall have occasion to consider some of thetheories of trade cycle causation evolved by the disputants in theFree Banking versus Central Banking controversy. Both sidesproduced evidence to show that financial and industrial crises werenot the fault of the particular system they advocated. The mostsatisfactory theory yet offered in explanation of booms anddepressions, however, is one which at that time was undevelopedand which finds the perpetually disequilibrating force in monetarydisturbances expressing themselves in a divergence between the“natural” and market rates of interest and between voluntarysavings and real investment. This divergence is in some wayconnected with bank policy, and the question then arises: How canbanks continually act as disequilibrating forces? It might be



supposed that if banks made mistakes as a result of which theysooner or later found themselves in difficulties, they would infuture act differently on the basis of their revised estimates of theiropportunities. Such we should expect to be the consequences,provided the banks had to submit to the full effects of their acts.One of the questions which must be put is whether thisresponsibility condition is not too often shelved by certain featuresof the particular system of banking organisation which has beenfavoured by the modern world. While recognising that themaladjustments may be due, not to the specific form of the bankingsystem, but rather to at present unresolved technical difficulties,common to any system, in maintaining equilibrium between savingsand investment, or in stabilising the effective quantity of circulatingmedia, it seems not improbable that the tendencies to misdirectionare magnified by the form of the system, in particular that part of itwhich entrusts the determination of the volume of credit to a singleauthority, between which and the Government there existreciprocal incentives to paternalism. It is not unlikely that thebolstering up of banking systems by their Governments is a factorwhich makes for instability.




CHAPTER II

The Development Of Central Banking InEnglandIt must have been generally true that, chronologically, depositbanking preceded the issue of notes. At least this was so in Englandand in the early banks at Hamburg and Amsterdam. But banking ingeneral only became important with the development of the issueof notes. People would deposit coin and bullion with a banker morereadily when they received something in exchange such as a bank-note, originally in the form of a mere receipt, which could bepassed from hand to hand. And it was only after the bankers hadwon the public over to confidence in the banks by circulating theirnotes that the public was persuaded to leave large sums on depositon the security of a mere book-entry. Moreover, bankers could onlylend out any great part of what was deposited with them if theycould pay out notes in case depositors should suddenly want morecash. And so it was that when the advantages of deposit bankingfirst came to be generally recognised, the most rapid strides weremade by those countries where the use of bank currency had beenmost widespread.

It was in note issuing, then, that the earliest banking problemsarose, and it was here that Governments threatened most stronglyto establish monopolies under the system of concession by charter.When banking was in its infancy, doubtless many mistakes weremade,1 and there was some justification for a Government’sinterfering at least to prevent fraudulent operations. And it is veryrelevant here to point out that when banking was making its firstexperiments, industry and trade were only just being weaned frommediaeval protectionism, and it took at least a century for the newsystem to organise a commercial code for large-scale enterprise.The practical non-existence of company law in general before thenineteenth century was especially serious in spheres touching thecurrency of a country: what damage could be done was likely tohave particularly widespread effects, since the whole populationdealt in money. But it must be admitted that it is almost certain thatby far the most powerful reason leading to the maintenance ofGovernment intervention in the banking sphere, at a time when itwas on the decline in other industries, was that power over theissue of paper money, whether such power is direct or indirect, isan exceedingly welcome weapon in the armoury of State finance.



As deposit banking became, from about the ‘thirties of last centuryonwards, more important relatively to the issue of notes, thedispute that had arisen about monopolies in the note-issuingbusiness tended correspondingly to diminish in importance,although it could not fall entirely out of the discussion because ofthe intimate connection between the two branches of the bankingbusiness. Deposits must always have at the back of them asufficient reserve of currency, and therefore the total amount ofcurrency must be a major factor in the determination of the totalvolume of deposits that can be created through the lendingoperations of the banks. Thus, if a central banking authoritycontrols the issue of notes, it also controls, though less rigidly, thevolume of credit.

Assuming that a paper currency is a desirable adjunct to acountry’s commercial development, we may conceive threealternative ways in which its issue may be undertaken:

a) It may be subject to the exclusive control of the State;b) It may be delegated to the control of a single privateinstitution;c) It may be left to the free competition of a large number ofbanks of issue.

The system of a single private institution may take various forms. Itmay be entirely independent of the State, or the latter may exercisecontrol over it either by taking a share in its capital and thusenforcing its will through its representatives on the directorate, orby subjecting it to the dictates, in matters of general policy, of aMinister of Finance. Even when the system is nominally free fromState control, however, history shows that virtually such a right willbe very difficult for the bank to maintain.

Also the plural system may vary in the nature of the legalframework within which it functions. There have been advocates ofa free system who have favoured certain special regulations; othershave assumed that the general clauses of a well-devised companylaw would be sufficient.

Again we should distinguish the case where a single controllinginstitution has an absolute monopoly from the case where it is thecentre of a so-called mixed system in which it certainly holds themajor power, but in which its monopoly is to some extent qualifiedby the existence of a number of other institutions exercising someof the same functions inside narrower limitations.

We can roughly summarise the course of events and swings ofpolicy in the evolution of banks of issue before 1875 under four



phases. The first was a preliminary period when banks were onlyjust beginning to emerge, and they were theoretically at liberty toform freely even if it was only because they were not yet obtrusiveenough to catch the eye of the legislative authority. In the secondperiod, monopoly, either absolute or to some extent qualified, wasdominant. The third phase was characterised by plurality andincreasing liberty, but by no means complete freedom. The fourthwitnesses the return to restrictions and monopoly, either absoluteor along the lines of a mixed system, with centralisation of control.

This scheme is more or less representative, with differences as todates, of the course of events in England, France and Prussia.Scotland and America fall outside it.

Let us now turn to the more detailed account of the historical factsof banking development that are relevant to our topic. Wecommence with England, which produced what later became amodel for many other countries.

The origins of banking in the modern sense are to be found inabout the middle of the seventeenth century, when merchants tookto depositing their balances of coin and bullion with the goldsmiths.The goldsmiths then began offering interest on deposits, since theycould re-lend them at higher rates, and the receipts they gave inacknowledgment of the deposits began to circulate as money. Therethus arose a number of small private firms, all having equal rights,and carrying on the issue of notes unrestricted and free fromGovernment control.

The second period in English banking, dating from the foundationof the Bank of England in 1694, was ushered in by an event of arather fortuitous political nature. Charles II had had to rely to avery large extent for his financial needs on loans from the Londonbankers. He ran heavily into debt and in 1672 suspendedExchequer payments and therefore the repayment of bankers’advances. The King’s credit was thereby ruined for several decadesto come, and it was to provide a substitute for the sources ofaccommodation thus destroyed that William III and his Governmentfell in with the scheme of a financier by the name of Patterson forthe foundation of an institution to be known as the Governor andCompany of the Bank of England. Its establishment was describedby the Tunnage Act, among the many clauses of which itsincorporation looked an absurdly minor event, as being “for thebetter raising and paying into the Exchequer of the sum of£1,200,000.”

The early history of the Bank was a series of exchanges of favoursbetween a needy Government and an accommodating corporation.



In the first instance, the Bank was founded with a capitalamounting to £1,200,000. This same sum was immediately lent tothe Government and in return the Bank was authorised to issuenotes to the same amount.2 This sudden issue of so many notesproduced all the usual accompaniments of a currency inflation. In1697 the Government renewed and extended the privileges of theBank, allowing it to increase its capital and therefore its note issue,and also giving it the monopoly of the possession of theGovernment balances by ordering that henceforth all sums due tothe Government must be paid through the Bank, a provision thatadded considerably to its prestige. Further, it was also providedthat no other bank should ever establish itself by the method ofacquiring a special Act of Parliament. Lastly, the Act stated that noact of the Governor and Company of the Bank of England was tosubject or make liable to forfeiture the particular private andpersonal property of any member of the corporation, a clausewhich bestowed on it the privilege of limited liability. This was afavour which was to be denied to all other banking associations foranother one and a half centuries.

It was just about this time that the new type of business entityknown as the joint stock company was taking hold, and it wastherefore an obvious step in the reinforcement of the Bank’salready privileged position to endow it with some sort of monopolyin this particular type of organisation, which was in so manyrespects superior to the old forms of business association.Accordingly, when in 1709 the Bank’s charter was renewed,besides allowing it to raise its capital in return for a loan to theGovernment, the relevant Act specified that no firms of more thansix partners might issue notes payable at demand or at any timeless than six months. This effectively excluded joint stock firmsfrom the note-issuing business, and, since banking in those dayswas held to be practically synonymous with note issue, frombanking business altogether. More than a century was to passbefore the application of the prohibition to banking business otherthan the issue of notes was to be called into question.

In 1713 the charter was further renewed, again in return for a loanto the Government, and as the resources for the loan were to beobtained by raising additional capital, the Bank gained at the sametime the right to an increase in its note issue. The 1742 renewalreaffirmed its privileges of “exclusive banking business,” and wasagain accompanied by the now customary loan transaction, thistime a loan without interest. After 1751 the Bank was entrustedwith the administration of the National Debt. In return for the 1764renewal of its charter the Bank paid the Government a fee of£110,000. There was another renewal and another loan in 1781and the same in 1800. In short, between 1694 and the beginning of



the nineteenth century the Treasury had benefited no less thanseven times by the successive renewals of the charter of the Bankof England,3 and this, quite apart from the short-termaccommodation given by the Bank in the ordinary course of itsdaily transactions.

The result of the accumulation of an array of privileges was to givethe Bank of England a position of prestige and influence in thefinancial world such as to cause small private banks to experiencedifficulties in continuing to compete in the same lines of business,and in London the majority of private note issues had beenabandoned by about 1780. A further effect was that the smallerbanks began to adopt the practice of keeping balances with theBank of England, which was thus already beginning to acquire thecharacteristics of a Central Bank.

The period 1797-1819 is interesting from our point of view, not onlybecause it provides an outstanding example of the force ofGovernment pressure on the Bank, but also because the ultimateconsequences of the Government’s policy towards the Bank were toadd to the latter’s influential position in the country’s bankingsystem. Soon after the outbreak of the French War, Pitt had to askfor advances from the Bank. Now the Bank Act of 1694 hadforbidden it to make advances to the Government without theexpress authorisation of Parliament. For a long time small amountshad nevertheless been advanced on Treasury Bills made payable atthe Bank. The legality of this practice had been regarded asdoubtful; so in 1793 the Bank applied to the Government for a Billindemnifying it against liability for the loans it had made in the pastand giving it legal authority to continue such transactions in thefuture, on the condition, however, that they should be kept below acertain figure. Pitt lost no time in getting the Bill throughParliament, but very usefully neglected to insert the limiting clause,so that the Bank became henceforth virtually compelled to complywith Government requirements to any amount. By 1795 theseborrowings had become so excessive as to affect the foreignexchanges and seriously endanger the Bank’s reserve position, andthe Bank directors appealed to the Government asking Pitt to keepdown his demands on the Bank, and at the same time it contracteddiscounts to private customers. What Pitt did, however, was to takeall possible steps to facilitate the Bank’s lending to theGovernment. The old dislike of small notes was thrown to thewinds:4 £5 notes were issued for the first time in 1795, and £1 and£2 notes were issued in 1797 in order to provide small currency inconjunction with another measure of that year, namely, thesuspension of the payment in cash of the Bank’s notes. Thissuspension of cash payments was procured by the Government byAct of Parliament in order to meet a critical situation in which the



Bank was faced by a “run” at a time when it already had anextremely weak reserve position. The Government’s actionamounted to a legalisation of the bankruptcy of the Bank, and itcreated a precedent which led the public in future always to expectthe Government to come to the aid of the Bank in difficultcircumstances.

We cannot here enter upon a discussion of the contribution ofcauses other than the Government borrowings, to the Bank’sdifficulties before 1797. Let it suffice to remark that the expansionof credit that the Bank was forced to undertake under Governmentpressure must, besides having been itself a cause, also haveweakened the Bank’s capacity to deal with these other causes,since the method of dealing with an outflow of specie, fromwhatever cause it arises, must be a contraction of credit.

Throughout the period of the rapid depreciation of the pound after1800, when there were phenomenal increases in bank credits forwar finance, Bank of England notes had for all practical purposesthe character of legal tender currency. They were not officially sodeclared prior to 1812, but since they were taken in allGovernment payments, and perhaps partly out of patriotic motives,they were usually accepted at par. Finally in 1812 the Governmentdeclared them to be legal tender for all payments. These eventshad important effects on the position of Bank of England notes inthe country. The country banks began to look on them as backingfor their own note issues, and in many parts of the country theytook their place in the local circulation for the first time. Anothereffect of the war experiences was to give the impetus to the firstdetailed discussion of banking and currency, ushered in by thereport of the Bullion Committee, and continued with unlaggingvigour till well over the turn of the half century.

There is no doubt that the release of the Bank from its obligation topay in cash proved very profitable to it. The Bank’s interest in thesuspension was stressed by several later observers. Gallatinremarks5 that its declared dividends rose from 7 percent to 10percent, besides £13,000,000 of extraordinary profits, and Hornwrites6 that on the morrow of its resumption of cash payments itsshares fell 16 percent.

The return to more or less normal conditions in 1819 brought withit, already, a tendency to regard the Bank of England as aregulating institution holding some special position of duty in thecurrency and credit system of the country, and, indeed, the Bankdirectors made a representation to Parliament protesting againstwhat they regarded as an attempt to establish a system which



would place upon them the responsibility “for supporting the wholeNational Currency.”7

Despite the fact that the Bank of England note ceased to be legaltender, the country banks tried to keep their customers to the habitof taking Bank of England notes in lieu of gold, and there was bythis time very little gold left in the provinces. The country banksstill needed gold to cash their own small notes, since the Bank didnot issue notes below £5, but in case of extra strain, the Bank’sstock of gold in London had already become practically the solesource of supply. Furthermore, the country banks were coming toexpect the Bank to lend to them in times of stress. At such timeswhen the notes of country bankers lost their acceptability, thepublic showed no hesitation in taking the notes of the Bank ofEngland, and these served just as well as gold coin to meet aninternal drain of cash. In the 1825 crisis the Bank was at firsthesitant about assisting the country banks, but after a week or soturned round and lent freely to them. It assisted not only with goldbut also with the re-issue of the £1 notes that had been incirculation in the restriction period, since £5 notes were unsuitableas everyday currency for small transactions.

The blame for the 1825 crisis was laid on the country banks andtheir issues of small notes. There were at this time between sevenand eight hundred of these banks in existence, and between 1810and 1825 about one hundred and fifty of them had becomebankrupt. There emerged an agitation in favour of allowing jointstock banks, other than the Bank of England, to set up, on thegrounds that the present private concerns of not more than sixpartners were too small to be solid and that joint stock companieswould be much stronger and more stable. It was pointed out thatnot only were small groups of inexperienced traders allowed to gofreely into the banking business, but that under the existing law itwas only these who could do so, and that if concerns with greaterfinancial backing could set up, they would drive out the bad firms.The prime mover in the campaign for joint stock banking wasThomas Joplin, whose pamphlet of 18228 called attention to thegreat success of the Scotch system, and who was later to take aleading part in the foundation of the National Provincial. The Bankof England opposed the proposals relentlessly and countered themby suggesting that it should set up branches itself in the provinces.Lord Liverpool and his colleagues replied that the proposal of theBank for establishing branches would not be sufficient to providefor the needs of the country. Incidentally, Liverpool,9 in trying topersuade the Bank that an improvement in the country circulationwould be to its own advantage, hinted at the growing tendency forthe Bank of England to become the centre of a single gold reserve,



the sole depository for gold in times of favourable exchanges andthe sole resort for obtaining it in the opposite circumstances.

The success of this campaign marks the beginning of a third period,a period of increased liberalism in English banking. By the 1826Act joint stock banks were permitted to establish outside a sixty-five mile radius from London and the Bank of England wasauthorised to set up branches. The presumed evil of small noteswas met by an Act of the same year prohibiting the issue of notes oflower denomination than £5.

By this time it had become obvious that banking business did notconsist solely in the issue of notes; nor was this necessarily themain department of banking. Another branch of banking had takenroot and was awaiting further development: deposits subject todraft by check were already an important feature of thecommercial world. The urgency of the demand for the free right toissue notes therefore subsided into the now more important needfor greater freedom in the establishment of deposit banks. It wasdecided that the charter rights of the Bank did not include anymonopoly of deposit banking, and in 1833 the Act for the renewalof the Bank Charter accorded the permission for joint stock banks,not issuing notes payable to bearer on demand, to set up inLondon. The first bank to set up under the new provisions was theLondon and Westminster, followed by the London Joint Stock Bank,the Union Bank of London, and the London and County Bank.10

The 1833 Act also made Bank of England notes legal tender (exceptby the Bank) for sums above £5 so long as they should maintaintheir convertibility.11 The result of this was to strengthen thetendency towards making the metallic reserve a single reservesystem in the hands of the Bank of England. Gold still had to bekept on hand at all ordinary times for making payments below £5,but in times of extra heavy demands, especially in times of panic,the country banks paid out Bank of England notes when their ownnotes were presented, or their deposits withdrawn, and theultimate demand for gold fell on the Bank of England. From this itwas not a very far or unnatural step for the banks to adopt thepractice of keeping the greater part of their reserves in the form ofbalances at the Bank to which they looked to get Bank noteswhenever necessary. In this way the Bank became the holder notonly of the gold reserve of the whole country, but also of thebanking (cash) reserve.

Between 1826 and 1836 about a hundred joint stock banks of issuehad been founded, and of these about seventy had been formedduring the last three years, and it was on these that the Opponentsof a freer banking system blamed the crises of 1836 and 1839.



Criticism came especially from Horsley Palmer, then Governor ofthe Bank of England,12 and the question was again raised of therelations between movements in the country bank-note circulationand the Bank of England note circulation. The 1832 ParliamentaryCommittee13 had been unable to reach any definite conclusion asto whether or not the country issues usually followed movements inthe Bank of England issues. Palmer now contended that prior to1836 the Bank of England had followed up any tendency to anoutflow of specie with a contraction of its circulation, but that whatshould have been the influence of this policy had been renderednugatory by the imprudent credit facilities and low money ratesoccasioned by the issues of the joint stock banks. He claimed thatbetween 1834 and 1836 the issues of the joint stock and privatebanks in the country had together increased by 25 percent, andthat this had led to a continuous export of bullion until the Bankhad finally been obliged to raise its discount rate, an event whichhad caused the stringency on the money market in 1836.

It was also his opinion that banking provision had been adequateunder the system of private banks existing prior to 1826, and thatin face of this it was dangerous to encourage the formation ofadditional joint stock banks. He thought the merit of the privatebanks had been grossly understated. “Nearly eighty private bankssuspended their payments in 1825,” he says, “yet no stronger proofcould be afforded of the really substantial state of the countrybanks at that time than that a very small proportion (it is believednot ten) proceeded to bankruptcy.” Palmer’s allegations evoked asomewhat ironic reply from Loyd,14 who failed, he said, to find inthe Bank’s accounts sufficient evidence of Palmer’s contention thatthe Bank had, during the years under discussion, kept its securitiesconstant and contracted its circulation when specie diminished. Hefound rather that the reverse had been the case, and he very muchdoubted whether the joint stock banks had the power to extendtheir issues for any length of time should the Bank of England carryout a “regular, steady and undeviating course of contraction.” Loydwas claiming that the central issuer, whose notes were now lookedupon as reserve money by the joint stock banks, had both thepower and the duty to control the action of those banks, while theBank directors still refused to accept that responsibility. Loyd andhis followers considered at the same time that the indirect power ofcontrol of the Bank of England was insufficient because theCountry note issuers were late in following up contractions by theBank of England.15

Most of the discussion after this time centred round these problemsof central bank policy and the effectiveness of the control it hadover the total circulation and the necessity or lack of necessity forlimiting note issues to a predetermined figure. In England the



currency and banking controversy tended to overshadow the widerissues of free banking. The two problems were, of course, notentirely independent, and their interconnections will be consideredin a later chapter. All that concerns us here is that it is the finalvictory of the currency school in 1844 which brings us to our fourthperiod and the decision, at least in practice, in favour of a centralbanking single reserve system. It was the 1844 Act which ensuredthe ultimate monopoly of the note issue in the hands of the Bank ofEngland. It provided in the first instance that the Bank of England’sfiduciary issue should be limited to a figure of £14,000,000. Theother banks of issue at that time in existence were to be allowedthe continuance of the right to issue, but the maximum limit of theissues was fixed in each case at the average figure their issues hadreached in the period just preceding the Act, and their rights wereto lapse altogether if they amalgamated with, or were absorbed by,another bank, or if they voluntarily renounced their rights, and theBank of England was to acquire such rights to the extent of two-thirds of the authorised issues of the banks concerned. No newbank could acquire rights of issue.

Horsley Palmer now invoked the position of the Bank as, whatBagehot later christened, the “lender of last resort” as grounds foropposing Peel’s Act.16 It would, he said, put the Bank in a verydifficult position for rendering aid to the market in times like 1825,1836 and 1839. Peel’s hope that his measure would render suchsituations much less likely to occur was, as events proved, to beunfulfilled. The 1847, 1857 and 1866 crises showed theGovernment always ready, on the only occasions when it wasnecessary, to exempt the Bank from the provisions of the Bank Act,and the Opinion was naturally expressed in some quarters that theclause of the Act, limiting the fiduciary issue of the Bank, was amere paper provision having no practical application, since theBank of England could always rely on the Government to legalise abreach of it every time it got into a difficult position. The relationsbetween the Bank and the Government were, in fact, a tradition toolong established for either the Bank, or the public, or theGovernment, to envisage anything other than full Governmentsupport to the Bank in time of stress. It had always been aprivileged and protected institution, and it was in the interests notonly of the Bank but also of the Government that it should remainso.

The Bank directors were extremely loath to recognise the delicacyof the Bank’s position in a system which, as the result of a longseries of Government manipulations, had made it the controllingelement in the country’s credit structure. It was the nature of thisresponsibility that Bagehot was analysing in his “Lombard Street.”



Looking at the 1844 Act from our position of superior knowledge ofwhat were to be the features of later banking development, inparticular the amalgamations of the last quarter of the nineteenthcentury, it is impossible to ignore the anomaly of the situation inwhich this Act left the provincial note-issuing banks. Since theywere prohibited from acquiring by purchase or absorption thecirculation of other banks of issue, there was a tendency towardsthe preservation of the smaller banks, even when it would havebeen more economical for them to combine, because it mighthappen that the profits to be obtained from the retention of thenote issue were estimated to be greater than those to be obtainedby joining a larger concern. Secondly, joint stock banks whichengaged in the note-issuing business were excluded from theLondon market and had to pay correspondents to pay out theirnotes in London. A striking case in point in this respect was theNational Provincial Bank. This had been founded, not like theLondon and Westminster Bank as a London bank without note issueunder the 1833 Act, but under the 1825 Act as a joint stock bankissuing notes. Thus, although this bank had a head office in Londonfrom which the general administration of all its branches wasconducted, it was excluded from carrying on any banking businesswhatsoever in the metropolis. It was these anomalies thatGladstone sought to remove in the Country Note Issues Bill heintroduced in 1865. In return for the removal of the disadvantagesmentioned above, those banks choosing to take advantage of itsprovisions (it was to be a permissive Act only) were to pay a tax of£1 percent on their authorised circulation, and the Governmentwas, besides, to have the right to terminate their issues altogetherafter a period of fifteen years. Hankey and Goschen got this clauseof the Bill amended so as not merely to empower the Governmentto terminate the issues of such banks after fifteen years but tocompel it so to do. It was thus to become an instrument for gettingrid of the country circulation altogether, but Gladstone so wordedthe preamble as not to preclude entirely negotiations for a renewalof the term. The Bill failed to pass, however, and in 1866 theNational Provincial, probably the bank most concerned, started abanking business in London at the price of sacrificing its right toissue notes. From this time onwards the joint stock banksconcentrated their efforts on deposit business.

The theoretical discussion lingered on a few years longer, largely asthe reflection of developments abroad.




CHAPTER III

The Scottish SystemBut for the fact that the Act of Union was just over a decade toolate, the Bank of England might have been the Bank of England andScotland. As it was, however, Scottish banking developed alongindependent lines. At the beginning, the practice of givingconcessions by charter was followed. The Bank of Scotland,founded by a group of Scottish merchants in 1695, only a year afterthe establishment of the Bank of England, received under Charterfrom the Scottish Parliament a monopoly for twenty-one years. ThisBank experimented almost immediately with a policy of setting upbranches, and it also issued notes for denominations as low as £1.When in 1716 the Bank’s monopoly expired, it protested stronglyagainst threats of competition, but without success, and in 1727 asecond charter was granted to the Royal Bank of Scotland.

The primary object of forming under special charter was that theBank obtained thereby the right to limited liability, but there wasno restriction in Scotland on the liberty of joint stock companies toset up in the banking business so long as the shareholders werewilling to accept unlimited liability for the debts of the association,and not much time elapsed before unchartered banks of this kindwere starting up all over the country.

Only one further charter was granted: this was to the British LinenCompany in 1746. All the other banks formed under the ordinarylaw. There was no restriction on the number of partners and, aftera short period of abuses in the experimental stage, banking cameinto the hands of a number of substantial joint stock companies ofconsiderable size and financial strength. The collapse of the AyrBank in 1772 after an over-issue of notes did a great deal ofdamage to the credit of the smaller banks; most of the little privatebanks went out of business and their place was taken by joint stockbanks or private banks with larger capital resources.

The Scottish system developed certain characteristics which earlydistinguished it from the systems in other countries. There waskeen competition between the banks and they kept very strictly tothe practice of regularly clearing each other’s notes; exchangeswere made twice a week and the balances immediately settled.They adopted branch organisation almost from the beginning, andthere was, as compared with other countries, a much more rapidgrowth of deposit banking and development of loan technique.



In 1826 there were, besides the three chartered banks (withtwenty-four branches), twenty-two joint stock banks (with ninety-seven branches) and eleven private banks, whereas in Englandlegislation was only just being passed to permit joint stock banks toestablish, and not even the Bank of England had yet set up anybranches. Right up to that time there had only been one seriousfailure in the history of Scotch banking—the Ayr disaster—and itwas computed that the total loss sustained by the public had notexceeded a figure of £36,000.

The Scottish network of solid institutions, free from legislativeinterference, with an already highly developed depositbusiness—its marked success and its freedom from the excesseswhich lead to suspensions—could not help but impress English eyesat a time when large numbers of the small country banks inEngland were foundering. Still more, perhaps, did it impress theprotagonists of free banking on the Continent.

The investigations by Committees of both Houses of Parliament in1825 into the supposedly evil practice of the issue of £1 notes andthe suggestion that it should be prohibited alike in Scotland as inEngland aroused bitter indignation in Scotland. The Scottishcommunity had become, by long use, accustomed to handling £1notes instead of gold in their daily transactions, and it wasconsequently not from the banking interests alone that the protestsderived. Notable among the antagonists was Sir Walter Scott. Itwas, indeed, difficult for the promoters of the 1826 legislation toclaim on the experiences of Scotch banking that the issue of £1notes had had any catastrophic results.

Scotland escaped the censure of its £1 notes, but had to submit tothe Peel regulations of 1845. These conferred a monopoly of thenote issue on the then existing Scotch banks. The fiduciary issue ofeach bank was limited to a maximum fixed on the basis of anaverage taken over the previous year, but, unlike the Englishbanks, the Scotch ones could issue notes above this fixed limit solong as they backed the extra notes a 100 percent by gold, and alsoif two banks fused they might retain a fiduciary issue equal to thecombined issues of both.

The regulation imposed by the Act was regarded withdissatisfaction for many years afterwards. In 1864 complaints werecoming from Scottish quarters that owing to bank extinctionsScottish note issues had diminished and Bank of England noteswere not fitted to fill the gaps because they were not issued belowthe denomination of £5. And for the comfort of the opponents ofPeel’s legislation the next thirty years witnessed two of the worstfailures the Scottish banking system had ever experienced,



comparable only with that of the Ayr Bank a century before. Thesewere the collapse of the Western Bank in 1857 and of the GlasgowBank in 1878.




CHAPTER IV

The Development Of Central Banking InFranceThe unfortunate first experiences of note issues in France retardedbanking development in that country for many years. The monopolygiven to John Law in 1716 for his Banque Générale resulted in adisastrous over-issue of paper, and the bank closed after five years.The Government thereafter raised the restrictions on the formationof note-issuing banks, but although firms set up to carry on otherbranches of banking business, chiefly discounting and exchangetransactions, no bank of issue was founded before 1776. This wasthe Caisse d’Escornpte, a partnership with limited liability, foundedby Turgot, the French Minister of Finance. From the verybeginning this bank came into very close relations with the State,and became, in fact, practically a branch of the financialdepartment of the Government. The promise of an advance of6,000,000 frs. to the Treasury in 1783 caused a “run” on the bankand it suspended payments. The exigencies of the State finances,already heavily in debt to the Caisse, resulted in the giving offorced currency to its notes in 1788, and after this followed theassignat régime. The first assignats, issued in 1789, which were notthemselves legal tender but short-dated interest-bearingGovernment bonds, backed by the biens nationaux, were usuallydiscounted with the Caisse. But in 1790 the assignats became legaltender currency. France was flooded with them and the Caissecollapsed, leaving behind it a distrust of paper money which was tobe widespread and long-lived.

A decree of 1792 had forbidden the establishment of banks of issue,but the abrogation of this decree and the restoration of theordinary currency in 1796-97 encouraged some of the Parisdiscount banks to undertake the issue of notes. Chief among thesewere the Caisse des Comptes Courants and the Caisse d’Escomptedu Commerce. A new development took place in 1798 when a bankof issue was set up in the provinces, namely, at Rouen. This banktook the step of issuing notes as small as 100 frs. The Paris bankshad not been in the habit of issuing notes for less than 250 frs. Thefreedom prevailing at this time in banking in France seems to haveproved very satisfactory, and no disasters occurred, but the marchof political events destined this state of affairs for a short existence.

Napoleon’s mania for centralisation and his difficulty in gettingGovernment paper discounted, chiefly owing to the lack of



confidence in that Government, turned his attention to thepotentialities of a bank founded under Government auspices. So in1800 he persuaded the stockholders in the Caisse des ComptesCourants to dissolve the company and merge it into a new bank,called the Bank of France. The Bank was financed with an initialcapital of 36,000,000 frs., obtained partly from the original capitalof the Caisse des Comptes Courants, partly by new subscription bythe public and partly from Government funds, obtained from thesinking fund of the national debt. Soon after the foundation of theBank the Government sold out a large part of its shares, but theindependence of the Bank was not thereby much increased.Further negotiations, and manipulations, largely quiteunscrupulous, were undertaken in 1802, as a final result of whichthe Caisse d’Escompte du Commerce was unwillingly induced tofuse with the Bank of France.

The most severe blow to competition came a year later, however,when the Government, by the famous loi du 24 Germinal an XI,granted to the Bank of France the exclusive privilege of issuingnotes in Paris, ordered those Paris banks already issuing notes towithdraw them by a certain date, and forbade the Organisation ofany bank of issue in the provinces except by the consent of theGovernment, which reserved the right not only to grant allprivileges of issue but also to fix the maximum of such issue. Thepretext for this piece of legislation was the slight financial crisis in1802, but, in fact, nobody had brought any accusation against thecompetitive banks.

From the outset the Bank of France was under continuous pressurefrom Napoleon. As early as 1804 a dispute arose between thembecause the Bank was not discounting Government paper cheaplyenough. Under this pressure the Bank discounted too much andissued more notes than it had the specie to maintain. This over-issue, together with the spread of a rumour to the effect thatNapoleon had sent away the metallic reserves of the Bank toGermany for military needs, saw the Bank in serious difficulties inthe following year. It had partially to suspend payment and itsnotes depreciated 10 percent to 15 percent. For this Napoleon laidthe blame on the Bank and determined to bring its constitutionmore under the Government. So in 1806 he gave the State a largershare in the Bank’s administration by replacing the Committeeelected by the stockholders by a Governor and two deputy-Governors appointed by the head of the State.

Further heavy loans to the Treasury in 1813 caused another partialsuspension of cash payments in the next year. This gave impetus toa good deal of criticism and to a movement of opinion in favour of



making the Bank independent of the Government, but nothingcame of this proposal.

It soon became apparent that France was extremely backward, ascompared with England and America, in the development ofbanking facilities; particularly slow was the pace at which theygrew in the provinces where, so far, and apart from small firmsspecialising on exchange business, they were practically non-existent. Special authority had been given to the Bank of France in1808 to set up branches, and in those towns where it establishedthem it was to have exclusive rights of issue. It set up its firstbranch offices in Lyons, Rouen and Lille, but they were all closeddown after a very brief existence, because they had provedunprofitable in the difficult years in which they had begun, and itwas also argued in favour of their suppression that their demandsmight, in periods of tight credit, encroach on the reserve of thecentral bank in Paris.

Almost immediately on the abandonment by the Bank of France ofthe attempt to establish credit facilities outside Paris, there was ashort period of increasing liberalism, during which three projectswere sanctioned by the Government of the Restoration for theestablishment of private departmental banks of issue. These werethe Banks of Rouen, Nantes and Bordeaux, formed in 1817-18. Butthese banks were subjected to severe restrictions, which were of anature to defeat any great expansion of their business. They hadthe right to issue notes only for their headquarters and one or twoother towns mentioned in their statutes; they could only discountbills payable in their own district; and their sight liabilities mightnot exceed three times the amount of their metallic reserves. Therestrictions of their operations to such narrow districts and theirinability to set up branches or employ agents almost belied the title“Departmental.” Their sphere of operations was infinitely smallerthan the département, and they were, in fact, merely small localbanks. Nevertheless, six additional departmental banks werefounded between 1835 and 1838, and the Bank of France, nowtaking fright at the threat of a competing banking interest, beganitself to organise branch offices, fifteen of which were startedbetween 1841 and 1848. Each branch the Bank opened was ofcourse given a monopoly of the note issue in its own town.Moreover, Comptoirs of the Bank of France required for theirauthorisation only an ordonnance royale, which would be grantedon the recommendation of the Conseil Générale de 1a Banque,whereas departmental banks after 1840 had to obtain a special Actof Parliament. Also the greater area over which the Comptoir as amember of a branch system could conduct business gave it a greatadvantage over the departmental bank. There never evendeveloped among the departmental banks any system of exchange



of notes: nevertheless, the success of these banks and the servicesthey rendered to the community were far from insignificant. Theymet with the disapproval of the Bank of France and after 1840 theGovernment refused to grant any more charters for theirfoundation. So the movement towards greater freedom in the note-issuing business was brought to an end. The representations of thedepartmental banks to the Chamber of Deputies, on the occasion ofthe discussions of the renewal of the charter of the Bank of France,asking for modifications of their statutes in the direction ofremoving some of the restrictions they contained, were alsounsuccessful.1

The trend of policy towards complete centralisation of the noteissue reached its logical conclusion as a result of the 1848 politicaldisturbances, but the opposition voiced by the Bank of France tothe renewal of the charter of the Bank of Bordeaux in that yearmakes it practically certain that the departmental banks would inany case not have survived after the expiration of their charterrights.

The 1848 political crisis foreshadowed in many people’s minds arepetition of the assignat regime, and their first instinct was tohoard specie, with the inevitable consequence of a run on thebanks. The Government was naturally interested in preserving thecapacity of the Bank of France to give it financial support in dealingwith the insurgents. It therefore gave to the Bank’s notes coursforcé and allowed it to issue notes for 100 frs.,2 at the same timeimposing what it regarded as a safeguard against excessive issuesby putting a maximum limit of 350,000,000 frs. on its note issue.The departmental banks were, it is true, given what were nominallythe same facilities, and their notes subjected to a maximum limitwhich amounted to 102,000,000 frs. for all nine banks together, butsince their notes were made legal tender only within their ownrespective localities, while the notes of the Bank of France werelegal tender all over France, the circulation of the Bank of Francegained an overwhelming ascendancy over that of the departmentalbanks. The 1848 decree was consequently their ruin rather thantheir salvation, and in the same year they agreed to submit to afusion with the Bank of France, practically the only course thatremained open to them short of liquidation. Thus by twoGovernment decrees they became Comptoirs of the Bank of France,which acquired their authorised note issues as an addition to itslegal maximum.

The events of the period immediately following 1848 throw lightalso on the subordination of the Bank to the will of the Treasury. Upto the decree to which we referred above, the Government hadnever imposed any limitation on the amount of the note issue. It



had been content to rely, on the Bank’s obligation to pay specie ondemand, and on a prohibition of small notes. Now that both thesechecks were gone, it did, as we have seen, impose a limit, but thisthe Government showed itself ever ready to raise if it should formany obstacle to the Bank’s readiness to lend to the Treasury. Thedifficulties of the Bank of France in meeting its obligations in cash,which had been the avowed reason for legalising its bankruptcy,had, so far as its private commercial obligations were concerned,been of very short duration, and it showed itself ready at an earlydate to revert to cash payments. But the scale at whichGovernment borrowings at the Bank continued made its positionunstable. In June, 1848, and again in November, 1849, theGovernment had arrived at agreements with the Bank by which thelatter was to make regular advances of fixed sums during thesucceeding two or three years. At the end of 1849 the Bank hadreceived permission to increase its issue to 525,000,000 frs. By thistime, however, it had a very strong metal reserve (about400,000,000 frs.), and it had already begun suppressing therestrictive measures relating to the redemption of its notes, and itwould probably have decided in favour of a complete resumption ofcash payments much earlier if it had not been for the Governmentborrowing factor. If Treasury demands were going to continue atthe same rate, the Bank believed its cash reserve would beinadequate. On the other hand, its note issue very soon approachedthe new maximum, and the Bank was faced with the choice eitherof applying for a further increase of its legalised circulation or ofreverting to its old statutes under which it would be obliged toredeem its notes and cours forcé would be abolished, but therewould be no legal limitation on the total volume of notes it wasallowed to issue. It was only after an agreement had been reachedwith the Treasury for the reduction of the Bank’s obligations tolend, that the Bank felt safe in reverting to its old statutes, and thisit finally did in August, 1850.

We have seen how France emerged from the 1848 political crisiswith a completely centralised, single, monopoly bank of issue. Theprogress of the industrial revolution in France round about 1850brought into greater prominence the extreme paucity of creditfacilities, most especially in the provinces, but even in Paris itself.Where facilities for the spread of a paper circulation had beenwithheld there was a corresponding absence of deposit banking,and the contrast was particularly strong with England where thecountry bankers with local connections and knowledge, even if theyhad rendered no other service, had at least accustomed the timidprovincial mind to banking habits. Courcelle-Seneuil, especially,stressed the practical impossibility in the rural districts of Franceof either borrowing or lending, except through the local notaire.Moreover, as he also pointed out,3 the fact that the farmers



received the proceeds of the sales of their crops and stocks in lumpsums at a particular time in the year and had to make theirdisbursements much more slowly over a much longer period meantthat they were in possession of balances of spare cash for thegreater part of the year. These balances could have been depositedin the banks and used to make short-term loans if there had beenlocal banks to deal with the business. As it was, the balances simplywent into hoards, and savings were not used.

We have now described the features which set the stage for theopening of the free-banking controversy in France. In addition, lesscommendable but nevertheless very powerful grounds wereprovided by the gradual emergence during the next two decades ofthe beginnings of a discount policy, the occasional stringency ofwhich evoked a torrent of criticism against the Bank of France.This particular aspect of the discussion is explained by aconception of the nature and object of banking which had itsorigins in the very earliest days of French banking. Right from thebeginning the Government had imposed limitations on theflexibility of discount rate. In the case of the Caisse d’Escompte itwas forbidden to charge more than 4 percent. The rate of discountof the Bank of France was fixed provisionally by the Government at6 percent, and for the first six years it was held invariable at thatfigure, until in 1806 it was reduced to 5 percent. Discount policy inthese years was primarily conditioned by the claims of Napoleon. Itwas his idea that the aim of the Bank of France must be to discountfor all commercial firms of reasonable standing at 4 percent, andhe criticised the Bank for not being liberal enough, and it was athis instance that the rate was reduced to 4 percent in 1807. It wasnot changed again until 1814, when it was raised to 5 percent. Itseems to have been the policy of the Bank to maintain as far aspossible a stable rate, for it was sticky in both directions, and whenthe Bank found it necessary to extend or to contract credit, it wouldadopt almost any conceivable means of doing so other than that ofadjusting4 the price it charged for its loans. In 1819 it adopted forsome months the policy of charging a lower rate (4 percent) on billsof short date (having less than thirty days to run) before it finallydecided to reduce all rates to 4 percent. In times of strain it keptthe rate of interest constant and resorted to rationing, or to thepurchase of specie at a premium, in order to strengthen its reserve.It was for the first time in 1847 that it discovered the effectivenessof a rise in the rate in stemming a drain of cash. It had alreadyrelowered its rate when the 1848 crisis brought another shock, andit was still too much afraid of using the weapon of discount rate tocombat it. It continued throughout the year to discount at 4percent, while the departmental banks, which were less able tobear the strain, were charging 6 percent. The reduction of the ratein 1852 to 3 percent brought to an end a period of just over thirty



years, during which, with the sole exception of 1847, its rate ofdiscount had remained unchanged at 4 percent. This is in strikingcontrast to the practice of the Bank of England, whose rate waschanged no less than fifty times between September, 1844, andDecember, 1856.

From the ‘fifties onwards the French rate began, however, tofluctuate more frequently. The greater willingness to change therate was probably strengthened by the greater need to do so,arising with the increased mobility of specie due to improvedtransport facilities and communications, which made arbitrageoperations much easier. Also, perhaps, some allowance should bemade for the beginnings of the activities of the Crédit Mobilier inthe direction of capital export. Anyhow, a strong tendency to anoutflow of specie set in between 1855 and 1857, culminating withthe crisis of that year. The Bank was at first hesitant about raisingbank rate, and in the autumn of 1856 the Governor asked theEmperor to sanction a suspension of cash payments. This theEmperor refused and the Bank next reverted to the practice ofimposing a limit (two months) on the échéance of bills it wasprepared to discount. Finally in 1857 it gave definite recognition tothe principle of raising bank rate when there is a drain on thespecie reserve, and in that year the Usury Laws prohibiting a rateabove 6 percent were abrogated so far as the Bank of France wasconcerned. But even so, the Bank still relied partly on the methodof charging higher rates on the longer-dated bills. In 1861 the ratewas held for some weeks at 7 percent, and from that time onwardsit fluctuated much more violently than heretofore, and began tooscillate more or less in harmony with the Bank of England rate.

In England the doctrine of bank rate was now fairly generallyaccepted, largely owing to the writings of MacLeod. But in Franceit provoked the first big attack on the Bank, and a correspondingdemand in some quarters for permission to establish other banks ofissue. Many of the adherents of this view pointed out that thecharter by which the Bank of France was granted its privilege didnot prevent the establishment in France of other banks of issue,that it was a monopoly not by law but in fact only and that theGovernment was free to give rights to other institutions in placesnot occupied by the Bank.

Increased practical significance was given to the discussion byincidents arising out of the annexation of Savoy in 1864, and it wasaround the Bank of Savoy controversy that the more generalquestion came to be focussed. Not the least disinterested andperhaps the most prominent among the participants in thediscussion were the Pereire brothers, founders of the new type ofcredit institution known as the Crédit Mobilier. This was a bank



which carried out underwriting, the marketing of bonds andequities, and even direct subscription to the newly issued capital ofindustrial companies, as well as to State loans. The founders hadprojects for setting up similar institutions in other countries. Thisthey failed to do directly, although the French Crédit Mobilier wasimitated independently in Germany. The Pereire brothers had fromthe outset always hoped to add to their other financial business thebusiness of note issue; this was incidentally a combination that hadexceedingly little chance of success, as was proved by Germanexperiences. Investments which consist for the most part ofindustrial securities and which are difficult to sell in certain statesof the market except at heavy loss prove very dangerous assets tohold against liabilities of the very shortest term, viz., notes payableon demand. The Pereires, however, saw no possibility of obtainingnote-issuing rights until the rights of the Bank of Savoy came up fordiscussion and reopened the whole question of free trade inbanking versus the monopoly of the Bank of France.

The treaties accompanying the annexation of Savoy establishedthat individuals and institutions belonging to Savoy should beallowed to exercise the same rights in France as they had heldunder the law of Savoy, and the Bank of Savoy concluded from thisthat it had the right to establish branches over the whole of Franceand to issue notes payable on demand. It was here that the CréditMobilier saw its chance. It concluded an agreement with the Bankof Savoy by which the Pereires were, by their own subscription, toraise a capital of the bank to ten times its present amount and gaina controlling influence in the concern. The Bank of France wasmuch alarmed at the prospect of having the Bank of Savoy as acompetitor, especially as certain features of the Bank of Savoy’sbusiness were likely to make it a keen rival. The Bank of Savoy paidinterest to depositors, issued notes for as low a denomination as 20frs., and could discount two-named paper, whereas the Bank ofFrance paid no interest on deposits and had not as yet issued notesfor less than 100 frs.,5 and could only discount three-named bills.The Bank of France made a protest on the plea of the Government’scontractual obligation to maintain its privilege, and obtained fromthe Minister of Finance a letter signifying the Government’sopposition to the Pereire agreement with the Bank of Savoy, andthen entered itself into negotiations with that Bank, as aconsequence of which the latter agreed to renounce its claims toissue notes in return for an indemnity.

This incident, together with the raising of the discount rate to 8percent in 1864, directed the attention of many people to thehitherto rather neglected subject of the theory of the moneymarket. Its immediate effect was to produce a demand for theappointment of a Commission to enquire into the policy of the Bank



of France. Isaac Pereire wrote a pamphlet demanding such anenquiry, and the Emperor received a petition from 300 Parismerchants also demanding an investigation, on the grounds thatthe raising of the discount rate by the Bank of France had led tothe periodic return of crises. Finally the Bank itself suggested thatthese demands should be satisfied, so that its position, in face ofthe attacks that were being made against it, might be elucidated.

The direction of the enquiry was undertaken by the ConseilSupérieur du Commerce de l’Agriculture et de l’Industrie. Thediscussions opened in February, 1865, and did not finish until June,1866, by which time much of the earlier enthusiasm had died down.The problems raised for discussion were primarily two: firstly,whether the Bank’s new policy of raising its discount rate in timesof strain was preferable to its old policy of maintaining its rateinvariable, and, secondly, whether a single bank of issue wassuperior to a plural system of competing banks. Evidence wastaken from practically all those having any competence to speak onthe subject. The results showed a verdict of the majority on bothissues in favour of the Bank of France.

This may be taken to mark the close of the discussion so far as thepractical issue was concerned, but among the more academicwriters it continued for several years longer, until it wassuperseded at the beginning of the ‘seventies by the bimetallicquestion. It was a strange coincidence that the Crédit Mobilier, thechief engineer of the accusation against the Bank of France, shouldalmost at the very moment of the Bank’s acquittal find itself inserious difficulties, which were to lead to its going into liquidationonly a year later.

At the same time as France was consolidating her centralisedsystem, the trend in neighbouring countries was in the samedirection. In Holland the debates in 1863 on the proposal to replacethe monopoly of the Netherlands Bank by free trade in the issue ofnotes had resulted in a decision in favour of the retention of themonopoly. In Italy increased centralisation of the note issue wasproceeding pari passu with political unification.




CHAPTER V

The Organisation Of Banking In America:Decentralisation Without FreedomThe Scottish experiences served as a forceful example in support ofthe claims of the free-banking school, but appeals to Americanhistory can hardly be said to have been so fortunate. The Americancase was evoked as evidence by both sides in the controversy, butso far as the system as a whole is concerned, it cannot be describedas an illustration for either. It was decentralised without freedom; itlacked the essential characteristics both of central banking and offree banking proper.

The distribution of powers between the Federal and the Stateauthorities left legislative control in banking matters in the handsof both. The country started off with a natural dislike of centralisedinstitutions and a jealous regard for individual State rights.Nevertheless, the need for funds in the War of Independenceimpelled the Federal Government to take the first initiative in thebanking sphere in the promotion of the Bank of North America. Thelack of a genuine commercial need for banking facilities at this veryearly period in America’s industrial development caused greatdifficulty in getting private capital for such an enterprise, and theGovernment was obliged to become a substantial shareholder inthe Bank. It shared the unpopularity of all central institutions, andafter the war its charter was repealed.

Not very long afterwards banks began to set up in the moreprogressive States under the separate legal systems of the variousStates concerned. The usual procedure at the beginning was toapply for a charter which gave the bank the privilege of limitedliability. In most cases the charter contained clauses limiting theamount of liabilities the banks might legally incur to a certainmultiple of their paid-up capital,1 and in some instances it imposedalso a lower limit on the denomination of notes. In very few Statesdid unchartered banks set up with unlimited liability.2 Almost assoon as any possibility arose of private individuals andunincorporated associations wanting to set up without charter,restrictions were placed on their entry into the banking business bythe legislatures concerned. Most of the eastern States passed lawssimilar to the 1818 law of New York, which made both depositbanking and note issue conditional on special legal authorisation,and the majority of the Western States followed up the same policy.But the actual effect of this rule varied from State to State



according to the ease with which charters were obtainable. Therewas least stringency in the east, which was, of course, the districtin which there was most call for banking facilities. The most liberalpolicy was to be found in New England and more especially inMassachusetts and Rhode Island, where charters were granted tonearly all who applied for them.3 In New York already establishedbanks seem to have exercised a powerful influence in persuadingthe legislature to refuse to grant charters to new competitors; andthere was an increasing tendency to restriction the further youwent south and west.

Meanwhile, a second attempt had been made to run a central bank.This was the Federal institution, known as the First Bank of theUnited States.4 From its parent bank at Philadelphia the companyhad early begun to develop branches, and this caused muchannoyance to the State banks and their legislatures. The oppositionof the Republican Party was forceful enough to secure itssuppression when its charter came up for renewal in 1811.

The disappearance of this bank and its branches was followed by arapid growth of State banks. In 1811 there had been about eighty-eight, and within the next three years a hundred and twenty newbank charters were granted. Most of these banks lent heavily to theFederal Government when war was declared in 1812, and theirexcessive issues caused about three-quarters of them5 to seek thesanction of their respective Governments to suspensions of cashpayments in 1814. After this their issues expanded still further andtheir notes fell to discounts ranging from 10 to 30 percent.6 Theresumption of specie payments nominally took place in 1817, but in1819 there was a further suspension, which lasted two more years.

The foundation of these early banks was much more often based onpolitical influence than on real commercial necessity. It wasattended by abuses in the paying in of capital which were oftendirectly aided by the State. In the case of the First Bank of theUnited States itself, the United States Government subscription of$200,000,000 was a purely fictitious book entry. Some of the bankshad scarcely any capital at all, and nearly all of them had much lessthan was nominally subscribed, and since the liability ofshareholders was limited, there was very little protection for thecreditors. The State legislatures, when they did at last setthemselves the task of opposing these fraudulent practices,experienced incredible difficulties in framing legislation to dealwith them.

Another feature of these early banking formations was their closeconnection with State Treasuries. It was a common practice forStates to require banks to make loans when necessary to the State



chartering them. Special provisions were often made for this intheir charters, and in addition Acts were passed from time to timeauthorising specific loans. The result of this frequently was that thebanks were so heavily “’loaned up” to the Government as to havepractically no substance left for supplying commercial demands, afactor which must have contributed considerably to their earlyexcesses.

The result of the autonomy of the rather small sparsely populatedarea of the State was that the banking system tended to assume avery fragmentary nature. A State bank had rights to carry onbusiness only within the borders of the State from which it receivedits charter. This meant that America could not develop a branchsystem of banking, and it was perhaps in this circumstance that thechief justification lay for an institution such as the First Bank of theUnited States. Secretary of the Treasury, Gallatin, expressed theopinion some years later that if the Bank of the United States hadbeen in existence in 1814, the chaotic banking disturbances of thatyear would not have occurred.7 The most essential condition forthe suppression of excess note issues is their presentation forpayment at frequent intervals. A very serious trouble throughoutthe history of American banking was the lack of a regular system ofclearing the notes of the various banks. Notes tended to travelconsiderable distances, and since a bank in one State had nobranches in any other State and generally no correspondentseither, there existed no ready-made agencies for collecting thenotes of rival banks and presenting them for payment. This was afunction that the First Bank had begun successfully to perform, andits consequences must undoubtedly have been to curb thetendencies of the local banks to excessive note issues.

Another experiment in centralised banking institutions was made in1816 with the foundation of the Second Bank of the United States.In common with the First Bank, part of its capital was subscribedby the Government, and it was to be the depository of the balancesof the Federal Treasury without obligation to pay interest on them.It had, moreover, the right to establish branches without consultingthe Governments of the States concerned. A new feature of itscharter was a clause intended to minimise the likelihood of cashsuspensions, by imposing a penalty, in the event of its failing tomeet its obligations on demand, in the form of a 12 percent tax onthe amount in default.

Gallatin maintains that it was only as a result of the organisation ofthis bank that the State banks were prevailed upon to resume cashpayments, since it was the Second Bank which proposed aconvention to which the State banks finally agreed. It is interestingto note that one of the stipulations made by the State banks was



that the Bank of the United States should, in any emergency thatmight menace the credit of any of the said banks, contribute itsresources to any reasonable extent in their support. This is a veryearly declaration of the view that it is the duty of the central bankto act as lender of last resort.

The Second Bank of the United States and its twenty-five branchessoon came into conflict with the defenders of State rights, and ofcourse the State banks backed up the opposition. The chiefobjection brought by the latter against the Bank was that it“accumulated their notes and then presented them for redemptionin coin.” “War” was declared on the Bank by Jackson when hesucceeded to the Presidency in 1829. The first blow was struck in1833 when he gave orders for the Government deposits to beremoved from the Bank and deposited instead in selected Statebanks. Shortly afterwards the renewal of the Bank’s charter wasvetoed. This put an end for many decades to all projects for acentral bank.

General suspensions of cash payments occurred in 1836, except inNew England, where the banks again kept above water. Probablythe worst feature of the American system and the one to which,combined with the exclusion of the entry of new firms, much of thechaos was due, was the extreme laxity with which principles ofbankruptcy were applied to insolvent banks. Take as an examplethe State of New York. In charters granted before 1828 there wereprovisions that if a bank suspended payment for a certain period(usually three months) it should cease operations unless it obtainedpermission to continue, after an examination of its affairs, from theChancellor of the Circuit, and if at the end of a year it still did notresume payment, it should surrender its rights altogether. Charterscreated after 1828 shortened the unconditional period allowed toten days. But in 1837 all these rules were made completelyineffectual because the State legislature passed a Suspension Actallowing suspending banks to continue for a year without applyingto the Commissioner. Other States followed New York’s exampleand passed Suspension Laws of an even more pernicious nature.8

Further suspensions took place in 1839, but were confined thistime to Pennsylvania and the States further to the south and west.Boston and the eastern States sustained payments. Pennsylvaniapassed laws legalising the suspension on condition that the banksshould make certain loans of money to the State, and it wasarranged that they should resume specie payments in January,1841. The obligation to lend to the Government naturally had theeffect of making it more difficult, if not impossible, for the banks toresume payments, and the date for resumption was postponed byanother Act which, in return for further subscription to a



Government loan, allowed the banks to continue the suspensionsuntil the loan was repaid, which might be any time up to fiveyears.9

The losses sustained by the Federal Treasury in the suspensions of1836 and 1839 called forth proposals for making the Treasuryindependent of the banks.

From the ‘forties onwards State banking showed signs ofimprovement. Most of the States had by this time succeeded inframing provisions for securing the paying up of capital bysubscribing shareholders. The more difficult task was to removethe tendencies towards expansions and to secure note-holdersagainst losses due to suspensions. A major deficiency over thewhole of the American banking structure had long been theinfrequency of the return of notes to their issuers. One of theearliest and most successful attempts to secure that notes wereredeemed more often was a voluntary system put into force by theSuffolk Bank of Massachusetts. Bank-notes circulated at placesdistant from their issuing bank at discounts varying with thedifficulty of sending them home for redemption. The smaller wasthe chance of its notes being presented for payment, the larger wasthe volume of notes that a bank could safely issue. The result of thelack of any machinery for ensuring the collection of notes wastherefore that banks began purposely to place themselves at longdistances from the most important centres of business. This waswhat happened in Massachusetts. The banks of Boston foundthemselves at a distinct disadvantage because the country bankswere securing practically the entire circulation even in Boston.Large numbers of country bank-notes never returned to the banksthat had issued them, but remained in Boston circulating withouthindrance at the recognised rate of discount. The Boston banksmade several attempts to systemise the sending back of notes forredemption. The most successful was the Suffolk Bank system.10This bank arranged for New England country banks to keep with itpermanent deposits of $5,000 plus a further sum sufficient toredeem notes reaching Boston. The Suffolk undertook to receive atpar the notes of banks who made such deposits, and the notes ofcountry banks who refused to come into the scheme would be sentback for redemption. The Suffolk Bank, moreover, refusedadmittance to its clearing agency to banks whose integrity was notabove suspicion. This had the intended effect of curtailing thecirculations of the country banks.

The Massachusetts legislature also passed a law, in 1843, to securethe more frequent return of notes by providing that no bank shouldpay over its counter any notes but its own. A similar law waspassed in Louisiana. Other States placed penalties on the default to



pay notes in specie on demand, either by the imposition of apercentage tax on the amount involved or by making the offendingbank liable to the forfeiture of its charter. This latter measureshould have been the most effective if it had been rigidly enforced.Specifications as to reserve requirements also began to emerge inmany of the States. The most stringent of these was that ofLouisiana requiring a specie reserve of one-third againstcirculation plus deposits.

In other cases efforts were directed not to preventing the over-issues and ensuring redeemability of notes on demand, but togiving some protection to the note-holder in the actual event ofsuspensions following such an over-issue. Several States adoptedthe practice of giving notes a prior lien on assets. Another measureadopted was that of double liabllity which made bank shareholdersliable for the debts of the bank to an amount equal to theirrespective holdings of shares over and above the amount of capitalactually invested by them in the bank. The most ambitious schemewas the New York Safety-Fund system.11 This was a system ofcompulsory insurance of banks against unmet liabilities. The bankspaid contributions to a fund to be allocated to the paying out of theliabilities of insolvent banks where they exceeded their assets.There was, of course, a tendency under this scheme to subsidiseweak institutions at the expense of the stronger and moreprudently managed ones, especially as the insurance premium wasnot assessed on the basis of actuarial risks, but was merelycomputed as a percentage on the capital of the bank. It also hadthe further unhealthy effect of weakening the public scrutiny overthe issues of particular banks, and many of the banks were temptedby this fact itself to risk bigger issues. Between 1840 and 1842eleven of the safety-fund banks failed, the fund was exhausted, andthe solvent banks had to be called upon for increased contributions.Future contributions were also mortgageAfterd in advance forcharges in respect of an issue of State bonds made to replenish thefund. the bankruptcy of the fund in 1842, it was made security fornotes only and no longer for deposits as well, but it still provedinadequate.12

We have already observed that the banking business in the UnitedStates, or at least over the greater part of it, was in the first halfcentury of its growth by no means open to free entry. But from1838 onwards there was a change of policy in several of the Stateswhich made it possible for banks to set up without having to obtaina charter. The new policy was inaugurated by New York in 1838 ina so-called Free-banking Law. Under this law it was madepermissible for any person or association to issue notes, providedthey had deposited with the Comptroller the equivalent amount inthe form of certain securities. All stocks of the United States and



those of States approved by the Comptroller were eligible, and, inaddition, certain bonds and mortgages on real estate. Should abank default on its notes, the Comptroller would sell the collateralsecurities in order to redeem them. The first effect of the newlygranted freedom was a wild dash to establish banks.

Immediately on the passage of the bill arrangements were made forthe formation of over a hundred and thirty new banks; about half ofthese had actually started business a year later and nearly half ofthem had gone out of business after another three years. The ideain the minds of many of the bank organisers seems to have beenthat if their notes were secured, nobody would ever demand theirredemption. Many of them set up solely for the purpose of issuingnotes, but in 1848 the State passed legislation requiring banks toundertake discount and deposit business as well as notecirculation.

The bond deposit system had the effect of tying up bank investmentin certain lines, usually Federal or State bonds. Mortgage and otherreal estate business soon proved to be too illiquid to providebacking for notes. It also had the rather peculiar effect of makingthe amount of the note circulation depend on the prices of Federaland State bonds. It meant also that while banks, constituted onother lines, could realise their assets in order either to get fundsfor redeeming their notes or to decrease the amount of notes incirculation, the bond deposit banks had very little chance of doingthis, because their capital was tied up in Government securitieswhich they were not free to sell until they had first reduced theirnote circulation, a feature which put them at a considerabledisadvantage in comparison with the chartered banks. Moreover,the system was by no means a perfect guarantee of noteredemption, because when a bank failed, many State stocks couldbe disposed of only at a discount.

Parallel with the beginnings of this movement in favour of a greatermeasure of competition, there took place in some other Statesfoundations of State monopolies. Early in the nineteenth centuryIndiana and Illinois had prohibited banks unless the State shouldjudge fit to establish one out of its own funds. The Bank of Indianaand the Bank of Ohio, founded in 1834 and 1845, respectively, wereboth State monopolies. Illinois followed the New York free bankingplan in 1851, and Indiana and Wisconsin did the same a little later.

The improvement that took place in American banking in thetwenty years preceding the Civil War was especially noticeable inthe eastern region. The banking system was by no means perfect atthis period, but except for the international crisis of 1857,13 whensuspensions of specie payments were general over most of the



United States, the situation was far steadier than ever before. It isvery probable that this improvement was not attributable to anyconsiderable extent to State regulations relating to bond depositguarantees for notes. In fact, the State authorities seem to havebecome, after a time, rather lax in the enforcement of the law, andthe State Comptroller was usually satisfied if the bank had in itsown possession the prescribed assets and was prepared to presentthem for his examination when he paid the bank visits on certaindays. This gave scope for a system of window-dressing by which thebanks passed round the same block of securities for exhibit on theappropriate days. The law was thereby rendered ineffective. Muchthe greater weight is to be attached to the more rigid enforcementof specie payments between banks by frequent exchange of notes,due in great part to the spread of the Suffolk system and to theinstitution of the New York clearing-house.14

The Civil War provided the occasion for a radical change in thebanking system of the whole country. The banks in the South gavetheir support to the secession and ceased remittances to the North,and since they had a large net liability towards the banks in theNorth the latter lost heavily, but they managed to keep above waterby contracting their lending operations and were, in fact, in a verystrong position regarding specie reserves. Pressure soon camehowever, from the side of Governmental financial needs. Secretaryof the Treasury Chase experienced excessive difficulty in borrowingfrom the public, partly as a result of the very bad state of thefinances in the preceding administration. Chase called a conferenceof the New York, Boston and Philadelphia banks, and with him theydrew up a plan for assisting the Government by advancing$50,000,000. Chase insisted on the loan being paid in specie, andat the same time he started the issue of United States notespayable on demand which further weakened the banks, since ifthey accepted the Government notes they were obliged to redeemthem in coin. The result was that at the turn of the year (1861-62)the banks of New York, Boston and Philadelphia suspendedpayments. The Treasury followed by ceasing likewise to redeem theTreasury notes in coin. This was followed up by a bill for issuinglegal tender irredeemable paper15 to the extent of $150,000,000, ameasure which was strongly opposed by the banks, among others.One of the chief arguments for making the Government notes legaltender was to force the banks to accept them. Two further issues,each of $150,000,000, were made within the twelve monthsfollowing. After that the issue of greenbacks was stopped, andChase had recourse to a new scheme for obtaining funds by thesale of Government securities, namely, the National Bank system.This was an extension to a National or Federal, instead of a State,basis of the bond deposit system. By an Act of 1864 banks of notless than five associates, and having a capital of not less than



$50,000, were allowed to form freely if they secured their notes bythe deposit with the United States Treasurer of registered bonds ofthe United States. The amount of notes must not be more than 90percent of the market value of the bonds lodged and not more than100 percent of their par value. In the event of a bank defaulting onits notes, the United States Treasury would sell the bonds and paythe notes itself. The Treasury also had a prior lien on the generalassets of the failed bank for any claims that could not be met out ofthe proceeds of the bond sales, and, further, the shareholders weresubject to double liability. The banks must also keep a certainreserve proportion of their notes plus deposits in the form of legaltender currency, which in the years of their foundation meant ofcourse greenbacks as well as specie. The primary motive for settingup this system was, of course, the creation of a large market forGovernment bonds, but it was contemplated from the beginningthat the new National banks would in time replace the old Statebanks and much emphasis was placed on the benefits of a uniformcurrency. Provisions were made in the original Act for State banksto come into the scheme by conforming to the conditions of the Act,and, as they failed to come in voluntarily as fast as the Governmenthad hoped, an Act was passed in 1865 to penalise those notentering the system by the imposition of a tax of 10 percent ontheir note issues. This was practically the death-blow to a greatnumber of the State banks so far as they were dependent on noteissue.

In the first years the notes of the National banks were not far shortof being legal tender currency, since, although their acceptancebetween individuals was not compulsory, the Government was toreceive them at par in all revenue collections except customs dutiesand to pay them at par for salaries, wages and debts, except forinterest on the public debt and the redemption of greenbacks.Moreover, since lawful money in which notes were to beredeemable meant greenbacks as well as specie, there was anexceptionally large volume of reserve material available againstwhich the National banks could expand their note issues. In spite ofall this, by 1867 a large part of the National bank-notes werecirculating at a discount against greenbacks and a number of theNational banks had already failed in that year.

It seems that people at first placed undue faith in the security ofthe new notes and perhaps regarded them as not liable to over-issue. For this reason the notes tended to keep out in circulationlonger without being sent in to the issuing bank for redemption andthere was thus lacking an effective check on the amount that anyone bank could keep in circulation, until it was presently realisedthat it is a mistake to regard a security backing as good as specie.



The really substantial improvement that might have been effectedthrough the National Banking Law was one that the authoritiesfailed to realise, namely, the provision of facilities for a branchbanking system. On the contrary the National banks wereforbidden, except under special circumstances, to establishbranches.

Some of the peculiarities of the bond deposit system as a means ofregulating note issues have already been mentioned in connectionwith the free banking system of New York. We shall have occasionto refer again to these problems in a later chapter on the Americanexperiences leading up to the Federal Reserve Act.




CHAPTER VI

The Development Of Central Banking InGermany1The history of banking in Germany, like that of the United States,should properly be considered in terms of the separate States, butit is impossible to do that here and we shall concentrate ourattention on the main events in Prussia, with an occasionalreference to the policy of other States. The setting in Germany isdissimilar to that in the other countries we have so far considered,for the reason that Germany at no time adopted true laisser-faireprinciples in her commercial policy, and therefore it is lesssurprising to find State intervention in banking in this country thanin any other.

The longer retention of mediaeval restrictions on the freecirculation of goods and services witnessed a corresponding lag inthe development of banking.2 But a good deal of literature waswritten about banks in the early eighteenth century, and there wasdetectable in most of these writings a mercantilist idea that thesetting up of banks would produce a sudden and conspicuousincrease in wealth.3

The first steps were taken by princes and nobles who, motivated byfiscal needs, attempted to start banking before its time, beforecommercial conditions were ripe for it, and they consequently metwith scant success at least so far as the note-issuing branch of thebusiness was concerned. The first bank of issue to prove at allsuccessful was the Royal Bank of Berlin, a State bank founded byFrederick the Great.4 It is doubtful whether even this one wouldhave been so fortunate in these years had it not had assigned to itby law certain deposits,5 and been given also the management ofthe Exchequer funds. As it began, so it continued, throughout thewhole of its existence, as a privileged institution under paternalprotection and in close relations with the State. The first effects ofthis were witnessed in the Napoleonic Wars, when it suspendedcash payments with Government sanction. The difficulties of thebank arose in the first place from the heavy loans it made to thePrussian Government, and they were later intensified by losses itsuffered as a result of the Peace of Tilsit, which took away fromPrussia certain Polish territories in which the bank had invested alarge proportion of its deposits on mortgage. These assets werecompletely lost to the bank. It emerged from the war with anenormous deficit, and after the cessation of hostilities it was



reorganised as a result of the war experiences and was madenominally independent of the Treasury and the Finance Minister,but its Chief remained, of course, a State official responsible to theKing.

No specific prohibition existed at this time against the formation ofprivate banks other than the obstacles that lay in the way of theestablishment of joint stock organisations in all lines of business. Inthe ‘twenties two private banks set up in Prussia and broke themonopoly of the Royal Bank by undertaking both deposit businessand note issue. These were the Berlin Kassenverein and thePommersche Privatbank at Stettin.6

But this period of relative freedom came to an end in 1833, whenthere was a complete reversal of policy. A law of that year made theissue of all bearer notes dependent on the approval of theGovernment. This virtual prohibition was prompted not out ofregard for the interests of the privileged Royal Bank, it must benoted, but to make way for the circulation of State paper moneywhich had originated in the time of the Napoleonic Wars and wasnow to be extended. The Royal Bank itself was included in theprohibition; all three of the Prussian note-issuing banks had to giveup the issue of notes. These increased restrictions on banking camealmost at the very moment when changes in industrial techniquewere about to swell enormously the demand for credit.

About this time banks were being set up in several other States:the policy in each case was restrictive. In Bavaria the Mortgageand Exchange Bank set up in 18357 was given a monopoly of thenote issue, not in this case as the result of a desire to give priorityto Government notes, of which there were none in Bavaria, butbecause of the fear that competition in the sphere of note issuewould be dangerous, and in accordance with this dread of too manynotes, we find a maximum limit to the note issue. A lessunderstandable regulation was that which compelled the bank toinvest at least three-fifths of its funds in land loans.

The Leipzig Bank of Saxony, founded in 1838, was not endowedwith an exclusive privilege but was subjected to equally rigidrestrictions. In this case the proportional reserve requirement (oftwo-thirds) was imposed in preference to the maximum limit on thenote issue.

It was in the ‘forties that the struggle for free trade in bankingbecame acute. In the preceding years capital had been relativelyabundant and interest rates low, but about the middle of the decadea reversion set in as the result of increased capital needs forrailway development, and interest rates rose. The public mind



entertained exaggerated hopes as to the power of banking. It was awidespread belief that all that was necessary to relieve a scarcity ofcapital was an elastic note issue, and the issue of notes was stillthought to possess something akin to a magic power oftransforming poverty into wealth. The philosophy of the SaintSimonians, which conceived of a reformed society in which thebanking system was given a central organising role in the assemblyand distribution of capital, had also spread to Germany. Thesenotions gave an impetus to two movements, the one demandingincreased note issues and the other looking towards the creation ofcrédit mobilier institutions.

Added to the demand for more capital, there was at this time agenuine currency difficulty. Very little gold was then in circulation,and in the absence of notes, payments had to be made in silver,which was very heavy to carry out. Notes were therefore found ofvery great convenience, and since they were relatively scarce, theywere often sought even at a premium. There began an agitationagainst the repression of private initiative, and the PrussianGovernment was overwhelmed with schemes for the creation ofprivate banks of issue to exist alongside the Royal Bank, all ofwhich it strongly opposed. The demand for private initiative tooktwo forms. One group merely wanted a private joint stock bank inplace of the existing State bank; others wanted to go much furtherand demanded nothing less than a system of independent freely-organised competitive banks.

The Prussian Government was led out of passivity into action by thenews that on one of its borders in the neighbouring state of Dessauthe authorities had approved the project for a note-issuing bankwhich had plans for extending its activities over the border intoPrussia. Although William IV commissioned Rother, the thenMinister at the head of the Royal Bank, to work out a scheme forthe establishment of private banks of issue, Rother dismissed theidea as being of not more than mere academic interest, andadopted the much less liberal alternative of reorganising the RoyalBank. This bank was still handicapped by lack of capital arisingfrom the deficit left by the French Wars, and the scheme that wasadopted was intended to replenish the assets of the bank and sostrengthen its lending capacity. Rother certainly envisaged a Statebank as the most desirable, but, probably owing to the lack of fundsin the State Treasury, he fell back on the introduction of privateshare capital into the bank. So it was reconstituted in 1846 as thePrussian Bank, now partly controlled by private shareholdersinstead of wholly by the State. It was given back the right of noteissue which it had formerly exercised, and its notes were graduallyto replace the State paper then in circulation, but the law specifiedboth a maximum limit to the note issue and a metal reserve



proportion to the extent of one-third8 of the note circulation. Thebank retained the privileges it had held as the Royal Bank, and itsnotes were made legal tender for public transactions. An importantclause in the decree establishing the bank and characteristic of thebanking notions of the period was that which stated specificallythat it was its express task to prevent any great rise in the rate ofinterest, and it was, in fact, forbidden to raise the rate for lombardbusiness above 6 percent.

But the extension of the note issue and the lending powers of thePrussian Bank did not suffice to quieten the agitation for greaterfreedom. The year 1847 was a year of very heavy demand forcredit. This was especially true of the west, in the lower Rhinelandand Westphalia, where industrial development was proceeding fast,and, although provision had been made in the constitution of thePrussian Bank for the establishment of branches, it had beenparticularly slow to develop them in these parts. Opinion in favourof private note-issuing banks became very strong, and its adherentsbegan to hold organised discussions on the subject.9

The excitement of 1848 brought a sharp turn of events. TheGovernment was persuaded to allow note-issuing powers to theBank of Breslau and to the Chemnitzer Stadtbank; it also set upitself State loan banks in connection with the Prussian Bank; finally,it took the far more radical step of granting concessions for thecreation of private note-issuing banks. But this was only a verygrudging gift to the free-banking party; the concession was in eachcase given for a period of ten years only, and, moreover, the bankswere over-regulated in the extreme. The celebrated Normativ-Bedingungen, under which they were established, restricted thescope of their business to a minimum. Besides the stipulation thatthey must keep a metal reserve of one-third against their noteissue, they were tied down to the smallest possible level of funds,and the lines of business in which they might engage were likewiserestricted. Their paid-up capital must not exceed a certain very lowfigure. The maximum note issue for all the provinces together wasfixed at a figure only one-third of the limit for the Prussian Bankand this total was divided equally among the provinces with noregard to their relative business needs. The banks were not allowedto have agents in other centres; they were not allowed to deal inGovernment securities that were not Prussian; neither could theydiscount bills whose acceptor lived outside the business place ofthe bank, and bills must be three-named; moreover, they were notallowed to pay interest on deposits, thus leaving such businessentirely in the hands of the Prussian Bank. So urgent was thedemand for notes, however, that the Berliner Kassenverein and theStettin Bank10 immediately subjected themselves to theseregulations in order to be able to exercise rights of issue.



Alongside the note issue campaign a second notion was beginningto exert an influence on the development of banking institutions inGermany. Almost as soon as the crédit mobilier idea was firstevolved in France it was taken up in Germany, and by the turn ofthe decade a number of joint stock banks were setting up in variousparts of Germany in crédit mobilier business. The Disconto-Gessellschaft in Berlin, the Schaffhausen’schen Bankverein inCologne and the Darmstadter were among the most important. InPrussia it was still difficult to establish even these, since joint stockcompanies had to obtain special Government concession beforethey were allowed to go into business. So it was that the Bank fürHandel und Industrie (later known as the Darmstadter) had to setup at Darmstadt because no concession could be obtained at thetime either in Prussia or in Frankfurt am Main, and the Disconto-Gesellschaft was a partnership for six years before it could obtain aconcession to become a joint stock concern.

The rate of progress in the setting up of note-issuing banks wasslow,11 and did not go far to meet the demands of the FreeBanking Party. Under the leadership of Harkort in the Chamber ofDeputies, this party secured the institution in 1851-2 of aparliamentary enquiry into banking and credit conditions inPrussia, and via these channels it gained more public attention. Onthe positive side the party demanded a relaxation of the Normativ-Bedingungen, and on the negative side it declaimed against thePrussian Bank as a half-State institution standing in the way ofprivate enterprise. Harkort tried hard but unsuccessfully to getlegislation passed for the removal of the Normativ-Bedingungen.

Some reforms did take place in the policy of the Prussian Bank; itbegan to adopt a more liberal lending policy12 and also extendedits branches in the western provinces.

In the smaller States note-issuing banks were being founded inconsiderable numbers, and their notes soon began to circulate justover the boundary in Prussia and Saxony. These small States issuednotes for lower denominations than the Prussian Bank, and thePrussian Government sought to exclude them from its territory byforbidding payments in non-Prussian notes for sums less than 10Rthlr. Saxony, Bavaria and Württemberg followed the same course,but the laws had no effect because the banks against whom theywere aimed merely replaced their 1 Rthlr. notes by 10 Rthlr. notes.

The Prussian Government saw that the only logical solution was toincrease the note issue inside Prussia. Two alternative ways ofdoing this were conceivable. One was to change the law relating tothe foundation of private banks and the other to centralise thebanking system, and give unlimited rights of note issue to the



Prussian Bank. Finally a compromise was adopted. TheGovernment gave unlimited rights of note issue to the PrussianBank and allowed it to issue notes of low denominations in returnfor a financial Operation which the Government regarded as veryfavourable to itself, namely, the commutation of half of its Statepaper money into interest-bearing State debt. Secondly,concessions were made in favour of private note-issuing banks.Four more received Government sanction to set up, and certain ofthe clauses of the Normativ-Bedingungen were modified so as toallow the private banks to discount two-named bills, to set upagencies, to issue small notes, and to take interest-bearingdeposits. The concession regarding interest-bearing deposits wassubject to the condition that the amount taken must not exceed theamount of the original capital of the bank, and that the depositsshould not be callable at less than two months’ notice.

Then the crisis of 1857 occurred, and this had a marked effect onthe later trend of policy. It provoked a reaction against the bankcreations of the ‘fifties13 and brought the beginnings of a changein attitude. The Prussian Bank was accused of having kept thediscount rate too low before the crisis, and one good effect thatcame of it was the renunciation of the limitation of the rate ofinterest to 6 percent. In the crisis itself the bank assumed what hadcome to be considered the functions of a central bank by lendingfreely to reputable firms who found themselves in difficulties. Theunlimited right of issue of the Prussian Bank was denounced, andthere was a crop of literature in favour of a 100 percent speciebacking for the note issue.14 The small Zettelbanken of the borderStates were condemned, probably justifiably in many cases, sincethey had attempted the impossible thing of combining créditmobilier business with note issue. Steps were taken to excludetheir notes both in Prussia and in Saxony. The Prussian Governmentforbade all payments in non-Prussian bank-notes. In Saxony theprohibition of foreign notes was to apply only if the note-issuingbank had no redemption centre in Saxony. The law was in eithercase ineffective in preventing the circulation of foreign notes; allthat happened was that the notes went to a discount because of therisk of legal punishment.

The Prussian Chamber of Deputies was by now divided into manyfactions over the banking question, ranging from a leaning towardsfull freedom for all banks to issue notes at the one extreme to apreference for complete unity in the note issue at the other. Thelatter was as yet unpractical because of the impossibility of keepingout the notes of the border States, and Prussia’s negotiations toobtain uniformity of policy among the separate States met withlittle success. The systematic discussion of the whole bankingquestion together with the formulation of a positive programme



was taken up by a private association of free traders, the Kongressdeutscher Volkswirte, foremost among whom was Dr. OttoMichaelis. The free-banking (Bankfreiheit) party had alreadysomewhat changed its ground. Bankfreiheit without any Stateintervention was no longer so prominent and was beginning to berelegated to a position of purely academic interest. The Congressopposed the too lax regulations of the “wilden Banken” of theborder States, but condemned the over-supervision of theNormativ-Bedingungen. They had by this time given up all hope ofever securing freedom for private banks in note issue, andhenceforth concentrated their efforts on trying to secure freedomfor deposit banking, on a joint stock basis, pointing out that it wasunfortunate that people persisted in regarding note issue as thechief object of banking.

The swing towards increasing freedom in the note issue wasslowing up. It received practically its last acknowledgment in 1863when certain of the restrictions on private note-issuing banks wereslightly modified; they were allowed to take additional interest-bearing deposits, the limit now being twice instead of once theamount of their paid-up capital, and the period of their concessionwas extended from ten to fifteen years. In the Chamber of Deputiesthere was still a good deal of criticism of the Prussian Bank, andmost especially of its unlimited right of note issue, and Michaeliswas recommending the passing of a Peel’s Act for Germany.

In the south of Germany the restrictions were still very stringent.Where there was not monopoly there was complete prohibition ofnote issue, as was the case in Baden and Württemberg. In boththese States the Governments had persistently opposed theestablishment of a note-issuing bank, and it was only in the Franco-Prussian War that one was conceded for the first time.

Most forces were now operating in the direction of securing furthercentralisation. The 1866 crisis impressed many observers with theadvantages of a strong bank which can give liberal accommodationin a crisis. The continual consolidation of political authoritieshelped to widen the area over which a common policy could bepursued. Prussia acquired new territories after the war of 1866 towhich the business of the Prussian Bank was extended, and theNorddeutscher Bund in 1870 gained control over bankinglegislation in all the member States. A reform of the law relating tojoint stock companies freed them from the obligation to obtainauthoritative concession, and this at last opened the way to theestablishment of non-note-issuing banks, which was all that thefree-banking party now demanded. The final impulse to theadoption of central banking was given to Germany’s experiences inthe first years of her operation of the gold standard.



At the formation of the Reich in 1871 the laws of theNorddeutscher Bund were extended to the whole of Germanterritory and a uniform currency was established for the first time;it was based on the gold standard, and the payment of the Frenchindemnity provided an easy opportunity for accumulating thenecessary reserves.

As early as 1873 a crisis occurred, however. The note issues ofthose banks which had had no maximum limit or which had neverpreviously reached their limit had risen very rapidly after 1871,and this was especially true of the Prussian Bank. When the Frenchindemnity stopped, the exchanges went against Germany, and goldstarted to flow out. Germany had had very little experience ofexternal specie flows, because when silver had been the standard ithad been very expensive to collect specie and export it, and thespecie points had therefore been very wide. Neither were theGermans familiar with the effect of a gold flow in rectifying theexchanges, and the immediate consequences of the first goldexports was a scare that all the gold was going out and thatGermany would be off the gold standard. The undue alarm thatthus arose had an important influence on bank policy. It brought inthe first place a sudden realisation of the uses of discount policy.German opinion had been very much influenced by English events,and especially by Peel’s Act, and following on English doctrine, itwas believed that in order to manipulate a discount policy it wasnecessary to have a specially constituted central bank, which wouldbe responsible for controlling specie flows.

These ideas were embodied in the German Bank of 1875.15 The Actwas closely modelled on the English Act of 1844, but far morestatutory requirements were imposed. The position of the privatenote banks was as follows: Thirty-three note-issuing banks wererecognised for the whole of the Reich and no new ones might beestablished. The fiduciary issues of all the banks, including theReichsbank, were given a legal maximum, and a reserve proportionof one-third against their total note issue was also imposed. If anybank relinquished its issue, the Reichsbank was to acquire anaddition to the same amount to its legal fiduciary issue. Submissionto the terms of the Act involved disabilities, however, in the form ofa restriction on certain types of business. Thus, if banks wanted tocontinue to issue notes they must not engage in acceptancebusiness; they might trade only in certain classes of bonds, mustnot engage in mortgage business, and could not discount billshaving more than three months to run.

The Reichsbank was constituted out of the old Prussian Bank,which was turned into a wholly privately owned concern, butretained the official administration with still very little control left



in the hands of the shareholders; it was consequently considerablyless independent of Government control than the Bank of England.The business of the Reichsbank was restricted to certain lines:discount and lombard business was subject to the same limitationsas in the case of the private banks, and the taking of interest-bearing deposits was permissible only up to a fixed sum. The notesof the Reichsbank were not made legal tender, but they were givenmuch wider circulation than the notes of private banks, in that,whereas a private bank might not pay out notes of any otherprivate bank except to the issuing bank or for payment to the placewherein the issuing bank was situated, notes of the Reichsbankmight be paid out by the receiving bank without restriction.

A private note-issuing bank was allowed to stay out from theprovisions of the Act, but if it did this it was to have its operationsrestricted to the territory of the State which gave it its right of noteissue.

The provisions of this Act secured to the Reichsbank the position ofa modern central bank.




CHAPTER VII

Discussions On The Theory Of The Subject InEngland And America Prior To 1848Although the discussion of free banking had its beginning inEngland, it never reached such large proportions there as it did onthe Continent. This may have been due to the much greater degreeof freedom that had always existed in England giving rise to a morerapid growth of banking there than in either France or Germany,and therefore to a less pressing need for reform. Moreover, by thetime laisser-faire politics had taken up its stand against privilegedmonopolies, the Bank of England and the system of which it hadbecome the pivot were far too well established to be easilyremodelled, whereas on the Continent the banking systems wereless firmly established and therefore more subject to discussion.

The discussion in England seems to have opened in connection withthe agitation for joint stock banking, commencing with thepamphlet of Thomas Joplin,1 of 1822, in which attention was drawnto the greater stability and freedom from failures of the Scottishbanks in comparison with the English, a circumstance which heattributed to the greater financial strength and general superiorityof the joint stock organisation in which the number of subscribingshareholders was unrestricted compared with private concerns inwhich the number of the partners was by law not allowed to riseabove six. It was impossible to ignore the anomalies of a law which,as Lord Liverpool remarked, permitted “every description ofbanking except that which is solid and secure.”2

The partial victory of what we may already call the free-bankingparty, in the law of 1826, gave added impetus to the generaldiscussion, and it was brought forward at several meetings of thePolitical Economy Club. This club had been founded by Tooke tosupport the principles of Free Trade, and it was not unnatural thatreference should be made to the possibilities of extending FreeTrade principles to banking. The chief adherent of such anextension was Sir Henry Parnell, who moved a discussion3 onwhether “a proper currency (might not) be secured by leaving thebusiness of banking wholly free from all legislative interference.”Much the same question was brought up on several subsequentoccasions.4 Parnell continued to hold that the issue of bank notesshould be subject to free entry in London as well as in theprovinces, and not subject to the monopoly of the Bank of England,



although three of the leading economists of the day, Tooke, G. W.Norman and MacCulloch, argued against him.

Parnell’s defence of free banking is contained in a pamphlet writtenin 1827.5 The evidence of the Scotch bankers before the House ofCommons Committee6 in 1826 had drawn his attention to thepractice of the Scotch banks in regularly clearing each other’snotes and paying the balances. This practice, he submitted, was ofprimary importance in a free-banking system and acted as a veryefficient check on the over-issue of bank notes. He contended thatin a free system it was in the interests of each bank not only tokeep its own issues within bounds, but also to exert its power inpreventing every other bank from forcing too much of its paper intocirculation.7 Banks will receive every day from customers, either asdeposits or in repayment of loans, notes of other banks, and nobanks will re-issue the notes of other banks in preference to issuingits own. It will return the notes of the other banks to their issuers.Now if any bank A receives by such means more notes of bank Bthan B receives of A’s notes, there will arise a clearing balance infavour of A, and A will require to be paid in gold out of B’s reserve.So it is concluded that if one bank over-issued its notes the otherbanks would acquire positive balances against it, and theconsequent drain on its reserve would pull it up in its expansion.This control by way of the clearing mechanism was one whichdepended not on the public’s presenting notes for redemption buton the banks’ reciprocally doing so, and it was a check which waslikely to work much more quickly than one which waited on theexternal drain of bullion set in motion by the falling foreignexchange rates. In Parnell’s own words: “It is this continualdemand for coin, by the banks on one another, that gives theprinciple of convertibility full effect, and no such thing as an excessof paper or as a depreciation of its value can take place for want ofa sufficiently early and active demand for gold. If in England thepower of converting paper into gold has not prevented an excess ofpaper, because the demand does not occur until long after theexcess has taken place, this is to be attributed to the system ofEnglish banking.”8

The opposition between the views of Parnell and MacCulloch wasgiven more definite expression in a pamphlet of MacCulloch’s9 anda reply to that pamphlet by Parnell.10 MacCulloch’s contributioncontains the first important theoretical arguments for the caseagainst free banking. So far as the whole circulation of the Countryis concerned, his view was that so long as convertibility on demandis enforced, the issue of paper money cannot depreciate its valuebelow that of coin. An over-issue can admittedly depress the valueof the whole circulation, gold as well as paper, in the countryconcerned, but immediately this over-issue takes place, gold starts



going abroad, notes are presented to the issuers for payment, andthey, in order to prevent the exhaustion of their reserves and tomaintain their ability to redeem their obligations, are obliged tocontract their issues, raise the value of money and stop the goldefflux. There is, therefore, in his opinion always a check on over-issues by way of the public’s bringing notes to the banks forredemption. Now on the evidence of this argument alone it wasopen for Parnell to reply, as in fact he did, that the obligations topay notes in gold, which MacCulloch invoked as a safeguardagainst the Bank’s over-issuing its notes, is just as effective in asystem of a number of banks as in the case of a single bank like theBank of England, that, in fact, this Bank had often over-issued andthat the principle of contraction had worked very imperfectly inthese cases because the Bank had always applied it too late.

MacCulloch had, however, developed his argument further thanthis in an attempt to show that the free system of banking would bemore liable than a restricted system to lead to the frequentappearance of the phenomena of over-issue, the reason being thatcompetition among a number of banks would cause one bank tolower its discount rate in order to increase its business, and allbanks would be forced to do the same. He anticipates that hisopponents might argue that the notes of the bank, taking theinitiative in the process of expansion, would be returned to it andthat, therefore, its own interest and the integrity of its reserveswould hold it back. In reply to this argument he denies that anysuch check would operate because when falling exchange ratescause merchants to demand gold in exchange for notes they willsend in for redemption any notes that first come into their hands.They will not enquire which bank has been the cause of the over-issue, and consequently only the same proportion11 of the excessissue will be returned to the over-issuing bank as to the non-over-issuing banks. Thus the non-over-issuing banks have to sustain partof the pressure, and if they wanted to maintain their reserves at thesame level as before they would have to reduce their issues whilethe policy of the expanding bank continued to encroach on theirreserves. It is exceedingly unlikely that these banks would becontent to go on losing business and reserves indefinitely, becausecarried to extremes the process would finally result in theirextinction and in the de facto monopoly of the expanding bank.They would thus be virtually forced to follow the policy ofexpansion in self-defence. The conclusion is that if one bank shoulddecide on such a policy, it will become general; the tendency to adrain of gold will fail to check it in its early stages; there will be alarge over-issue and finally a very acute crisis.

The essence of MacCulloch’s thesis is that the expanding bank isnot subservient to the control of the conservative banks, but that



the latter are, on the contrary, subservient to the former. It shouldbe noted that MacCulloch spoke only of the presentation of notesfor gold directly by the public, a check that can be held in any caseto come too late, since the exchanges are only affected after theover-issue has worked out its effects on the price and productionstructure and sown the seeds of a crisis. He ignored altogetherParnell’s point about the operation of the clearing mechanism.

MacCulloch gives also a second and distinct reason for not allowingfree entry into the note-issuing business. This relates not so muchto the possibilities of a general over-issue, but to the evils that mayresult from over-issue on the part of a single bank or a number ofbanks. It is obvious that when a failure of any particular bankoccurs, certain people, viz., the holders of the notes of that bank,will suffer loss, and it was MacCulloch’s view that the Governmentshould regulate banking in order to prevent such loss accruing topeople who were possibly unable to distinguish the note of a goodhouse from the note of a bad house, or, even if they did havesufficient knowledge to do this, might in practice not be in aposition to refuse to accept payment in the notes of any form forfear of losing their claims altogether.12 This is a particularlyforceful argument in favour of the suppression of notes of smalldenomination, since it is the class of people who will not usually bein receipt at any one time of sums above a fairly small amount (sayless than £5) who are mainly concerned. Actually the argumentthat MacCulloch himself stresses in favour of the prohibition of £1notes is the greater facility with which forged notes of smalldenomination are likely to pass.13

Another argument, in support of which MacCulloch gives very littleevidence, is that whereas the Bank of England takes care to keepgold reserves of a size commensurable with demands liable to arisein time of a crisis, if there were a number of competitive banks, noparticular bank would incur any sort of general publicresponsibility and each would trust to the efforts of the others. Thiswas, as stated, an argument that was weak a priori, and for whichthere was, furthermore, little practical evidence.

Influenced no doubt by the experiences of 1825 he was led also toremark on the advantages of an institution like the Bank ofEngland, which could render aid during a crisis by expanding itsissues and lending freely to reputable firms in distress. With thealternative system of a number of firms, no bank would be able toinspire the same confidence and to get its notes accepted; in timeof general distrust they would all have to contract their operationsinstead of expanding them.



Parnell’s reply to MacCulloch was directed mainly towards acriticism of the policy in the previous half century of the Bank ofEngland, and no attempt was made to answer MacCulloch’s maingrounds of objection to a diffusion of the rights of note issue.

Events in America at about this time were also calling forthcomments from writers in that country on the problems raised bythe issue of bank-notes. An influential contribution was made byAlbert Gallatin at the beginning of the ‘thirties.14 In reviewingAmerican banking history he was inevitably most impressed by thefrequency of suspensions of cash payments and was chieflyinterested to discover effective methods of controlling note issueswithin their proper limits. To this end he recommended the placingof much narrower limitations, both on the amount of the note issueand on other obligations that any bank might legally incur.15 Hebelieved that the best method of giving complete security againstthe danger of insolvency was for the bank capital to be invested inGovernment securities,16 but he doubted whether this would bepracticable in the United States because there was not a largevolume of Government stocks in existence. He was, however, veryfavourably impressed by the Scottish system,17 and refers to theextensive deposit business and the system of cash credits18developed by the Scottish banks. The most efficacious method ofpreventing excessive issues was, he believed, the frequentexchange of each other’s notes by the banks as practisedsuccessfully by the Scottish banks, the allied banks of Boston andthe Bank of the United States.19

In spite of his praise of the Scottish system, Gallatin was not infavour of extending free competition to note issue as opposed todiscount and deposit business. He did not explain the distinction byreasoning as did so many of his contemporaries that deposits,unlike bank-notes, had no effect on the total circulation andtherefore on prices. On the contrary, he specifically states that “Thecredits in current account or deposits of our banks are also in theirorigin and effect perfectly assimilated to bank-notes—and wecannot therefore but consider the aggregate amount of creditspayable on demand standing on the books of the several banks asbeing part of the currency of the United States.”20 There is nodoubt that he saw clearly not only the part played by checks drawnon current account on the total amount of circulating media, butalso the exact similarity between creating additional loans byplacing credits to current account as by issuing notes over thecounter. Presumably the reason he had in mind for distinguishingbetween notes and deposits was the difference in generality ofacceptability.21



Among Gallatin’s readers was G. W. Norman, a Director of the Bankof England.22 Norman rejected the thesis of Gallatin and Parnellthat the clearing mechanism can act as an efficient control overnote issues; he reasons that if the will to expand is common to allor to a majority of the banks the frequent exchange of notes will bepowerless as a check on over-issues, because so long as the banksexpand in step with one another, no debits will arise in theclearings.

It was his own view that while what he calls “the true andlegitimate objects of banking” could and ought to be left to freecompetition,23 note issue was the one case in a hundred wheremonopoly should be maintained,24 and he favoured to this end thecomplete abolition of all the country note issues.25

The first writer to give an explicit explanation of why competitionin note issue cannot be assimilated to competition in other tradesseems to be have been S. J. Loyd (later Lord Overstone). “Theordinary advantages to the community arising from competitionare,” he says, “that it tends to excite the ingenuity and exertion ofthe producers, and thus to secure to the public the best supply, dueregard being had to the quality and quantity of the commodity, atthe lowest price, while all the evils arising from errors ormiscalculations on the part of the producers will fall on themselvesand not on the public. With respect to a paper currency, however,the interest of the public is of a very different kind; a steady andequable regulation of its amount by fixed law is the end to besought and the evil consequence of any error or miscalculationupon this point falls in a much greater pro-portion upon the publicthan upon the issuers.”26

Loyd, Norman and MacCulloch were all in later years to becomeprominent members of the currency school and adherents of Peel’sAct. It is therefore less surprising to find them among theopponents of free entry into the banking trade than it is to findTooke in the same camp, for he, besides being one of the leaders ofthe Free Trade movement, was the foremost representative of thatschool of thought on currency and credit which came to be knownas the banking school. This group was opposed to the imposition oflegal restrictions on the amount of the note issue, and thought itshould be left to the discretion of the note-issuing authorities underthe force of the demand of the public, to determine the amount. Inspite of the support he gave to these views27 Tooke was violentlyopposed to leaving banking open to free trade. “As to free trade inbanking in the sense in which it is sometimes contended for,” hesaid, “I agree with a writer in one of the American papers, whoobserves that free trade in banking is synonymous with free tradein swindling.” Such claims “do not rest in any manner on grounds



analogous to the claims of freedom of competition in production—.It is a matter for regulation by the State and comes within theprovince of police.”28 This dictum of Tooke’s was quoted times outof number by opponents of free banking on the Continent andbecame for them something in the nature of a motto.

The 1837 cash suspensions in America again led to reneweddiscussion on that side of the Atlantic, and these discussionsexercised considerable influence on later Continental thought. Twowriters, Richard Hildreth and H. C. Carey, made out a strong casefor free banking. Hildreth29 denounced the protectionist spiritprevailing in American banking and contended that if freecompetition were allowed to replace the existing system of politicalinterference and monopoly, there would be far fewer excesses.Carey30 defended the American banking system on the whole,pointing out that even if not satisfactory in all respects it providedmore facilities than the banks of any other country, and hemaintained that failures had in fact been less frequent than inEngland.31 In a comparative study of the various systems appliedby different States within America he found that where entry intothe banking trade was most free, failures were least frequent, andhe submitted that the whole principle behind the restrictive systemwas bound to lead to over-expansions, for, he says, “the system ofprivilege in banking arises from the erroneous idea that banking isdifferent from all other trades; that it affords the means of makinglarge profits, and that the right to bank should be held as aprivilege to be sold to a few individuals. Communities acting underthis false impression demand large bonuses for its use, thusimposing upon the parties a necessity for trading much beyondtheir capital.”32 The Scotch system, although superior to theEnglish, he regarded as still not entirely satisfactory, because it didnot allow banks to form with limited liability.33

The weakest part of Carey’s work was the theoretical explanationhe invoked in support of the thesis that a restricted banking systemis more likely to cause economic crises.34 The argument he gives isone that gained some considerable following later in France andwhich is generally, though erroneously, believed to have beenstarted by Coquelin. It begins by assuming that if there are onlyone or a few privileged banks, there will be a scarcity of long-terminvestments. Part of those available will have been bought by thebanks themselves and the public will possess in the form of savingsa quantity of spare funds for which at the moment there is no veryprofitable outlet in investment. These funds will consequently beleft on deposit at the banks. On the basis of this the banks will be ina position to extend their issues, and they will, in doing so, makeliquid capital still further superabundant and deposits will againincrease. The process will repeat itself until at last the depositors



find an outlet for their funds, let us say abroad, and thereforewithdraw their deposits from the banks, thus causing anembarrassment to the latter, who are forced to call in their loans,and a scarcity of capital ensues. All this arises because as a resultof the first impediment to investments a great deal of capital hasbeen only temporarily lent to the banks but has been invested bythem in forms that cannot be immediately liquidated.35 The theorycontends that if more banks were allowed to set up, the bankstocks themselves would provide the public with opportunities fordirect investment, and instead of these funds being lent to thebanks only on short term they would be lent on long term and therewould be less tendency to disturbance.36

In contrast a very unfavourable attitude towards American bankingwas taken up by Condy Raguet.37 His book was of a more generaland theoretical nature than Carey’s and tried to sketch the wholeof the theory of money and credit relevant to the suspensions ofspecie payments. He pointed out that the principle of the balanceof trade and specie flow adjustments which was already familiar inthe theory of international exchange was equally applicable to thebalance of claims arising out of the issues of different banks in thesame town or groups of banks in different towns, and if allowed tofunction, this principle would keep the issues of individual banks incheck. This emphasised the importance of enforcing immediateredemption of notes on demand, and of the frequent exchange ofnotes and payment of balances between banks. Unlike Carey, hethought the best system would be to establish individualresponsibility (unlimited liability) of the shareholders, but doubtedwhether such a system could ever be put into practice in the UnitedStates where the limited liability form of company organisation wasfar too deeply rooted. He was strongly opposed to freedom to issuenotes in the wide sense but was very favourably disposed towardsthe New York bond deposit system. His explanation of how an over-supply of credit leads first to an industrial boom and then to a crisiscontains points which anticipate modern trade cycle theory. Theend of the boom comes when there is a demand for coin forexportation; the banks are called upon to pay their notes and mustin turn call upon their debtors; so money becomes scarce and theprices of property and commodities fall. “At the winding up of thecatastrophe, it is discovered that during the whole of this operationconsumption has been increasing faster than production—that thecommunity is poorer in the end than when it began—that instead offood and clothing it has railroads and canals adequate for thetransportation of double the quantity of produce and merchandisethat there is to be transported—and that the whole of theappearance of prosperity which was exhibited while the currencywas gradually increasing in quantity was like the appearance ofwealth and affluence which the spendthrift exhibits while running



through his estate, and like it, destined to be followed by a periodof distress and inactivity.”38

A fourth contribution was another essay by Gallatin.39 This is inthe main a plea for the rapid resumption of specie payments. Hehad by this time adopted an attitude that was unfavourable topaper issues in general. He consequently takes up the point of viewthat there should be a shift of emphasis away from the issue ofnotes to other banking facilities such as exchange operations, theremittance of money, the collection of debts, the investment of idlebalances, all of which could be carried on without the issue ofpaper money, and he looks forward to the time when banks will setup for these purposes without possessing rights of note issue. Hedistinguished two senses of the term “free banking”40 —“First,that all persons or associations should be permitted to issue papermoney on the same terms; secondly, that paper money may beissued by all persons or associations, without any legislativerestrictions.” The first sense in which, after the New Yorklegislation of 1838, the term came almost exclusively to be used byEnglish-speaking writers, Gallatin was prepared to uphold, butcompetition in general was not applicable to banking41 becausethe objects that it attained in the case of the production of acommodity, viz., a reduction in the cost or an improvement in thequality were not relevant to banking.

We have referred already on several occasions to the contention ofthe free-banking school that there exists in the competitive systeman automatic mechanism which operates to check expansions of thenote issue. The mechanism consists in the return of notes for goldto the bank or banks that over-issue. It has been already rejected(by MacCulloch) in so far as it depends on the presentation of notesby the public for gold. But it was held also to work through thereciprocal claims of the banks themselves upon each other’sreserves. We have mentioned, too, the objection (of Norman) thatthis also would be ineffective if all or most of the banks decided toexpand, and each kept in step with the others. We come next to anargument introduced by Mountifort Longfield,42 denying the forceof the mechanism, even in the case of an expansion by only onebank. He illustrates the argument by an arithmetical example. Letus suppose that there are two banks, A and B,43 who both carry onthe same kind of business, all of which consists in lending by way ofthe issue of notes. Suppose also that in the initial period of time Aand B did the same amount of business and held equal goldreserves, so that in each case—

Note issue =£40,000Gold reserve=£15,000



and every week each bank discounts £10,000 in bills and receivesthe same amount in repayment of previous discounts. We mayassume the repayments to each bank to be made partly in its ownnotes and partly in the notes of the other bank, the proportionsbeing roughly the same as the proportions the separate note issuesof the two banks bear to the total circulation. In this situation bankA will receive each week 5,000 of its own notes and 5,000 of B’s,and B will receive the same, so that the daily or weekly exchangesof notes will just balance with no transfer of gold from the reserveof one bank to the reserve of the other. Now suppose that bank Adecides to lend £20,000 more and increases its issues for thispurpose by the same amount while B maintains the old position.Then, in the new situation, the proportion between the note issuesof the two banks has changed from 1:1 to 3:2, and B will receive6,000 of A’s notes and 4,000 of its own notes, and it will return inthe week 6,000 of A’s notes to A. But since A’s business nowexceeds B’s business in the proportion of 3:2 also, A will discountweekly, and therefore have falling due for payment in any week,bills to the extent of £15,000, of which £9,000 will be paid in itsown notes and £6,000 in B’s notes, so that it also has to return to B6,000 notes. Thus the clearing account still gives no debit or crediton either side and no gold will be transferred. Consequently, B hasno automatic check on A’s expansion.

At a later stage the public starts demanding gold, however, and thisdemand will fall on the two banks in proportion to their shares ofthe total circulation. Suppose that the total demand is £20,000,44then in the final position A will have

Note issue =£48,000,Gold reserve=£3,000,

and B will have

Note issue =£32,000,Gold reserve=£7,000.

Thus the gold reserve of the bank which did not increase itscirculation has been diminished in greater ratio than its circulation,and if the managers wish to keep the same reserve proportion asbefore (viz., 15:40) they must reduce their discounts “from £40,000to about £30,000.” “Hence a bank of issue may have its golddrained off by a rival which, if it has capital enough, may even ruinits competitor. If to avoid this calamity it contracts its issues, itthereby enables its rival to extend its business still more, until atlast the more moderate bank is obliged to give up businessaltogether. Thus a bank may be driven in self-defence to take up thesystem of over-trading adopted by its competitors, and where there



are several joint stock banks of issue, the country will suffer underalterations of high and low prices, of confidence and panic, of greatexcitement and general depression of trade. That bank will gainmost which does most business during the period of excitement andis quickest and most resolute in contracting its issues and refusingto discount when the panic is coming. A system can scarcely bedevised more injurious to the prosperity of a great commercialnation than this of permitting everybody who wishes it to make andissue that which is to be its circulating medium at the same timethat it is their interest to issue as much as possible when the spiritof overtrading is prevalent and to reduce their issues when tradebegins to stagnate and wants a stimulus to revive it.”

Longfield’s general conclusion is therefore the same asMacCulloch’s, that far from the expanding bank being at the mercyof the conservative bank the latter is at the mercy of the former;there exists no automatic check on over-issues; on the contrary,rivalry among the banks leads to general expansion.

The point raised by the Longfield argument is by far the mostimportant controversial point in the theory of free banking. Noattempt was made in subsequent literature to reply to it, and weshall postpone the detailed examination of its validity until our finalchapter.

We have tried in what precedes to connect together a series ofrather disconnected remarks. There had been no organiseddiscussion of the free-banking question by itself. There was allalong a tendency in this country to accept the Bank of England’sposition and to concentrate attention on the banking and currencycontroversy and the general problem of central bank organisation.Probably the first discussion of the advantages of free competitionthat was anything like systematic was that given by James Wilson,first editor of The Economist, in a series of articles he published inthat journal between 1845 and 1847.45 When these articles werewritten the final decision against free entry into the note-issuingbusiness had already been made in the Bank Act of 1844, and theyare, as a not unnatural consequence, more an attempt to point outthe nature and the origin of the system that had by this timebecome established, rather than to make recommendations for theadoption of an alternative system, and their main object was todenounce the theories of the currency school.

The privilege and monopoly of the Bank of England is, in Wilson’sopinion, the cause of England’s lag behind Scotland, especially inthe development of deposit business.46 The more secure basis of,and the greater confidence of the public in, the Scottish banks wasthe outcome of the eminently satisfactory working of free



competition. There had never been any restriction in Scotland onthe number of partners allowed to combine to form a banking firm,and even before the advent of the joint stock company the firmshad always consisted of a large number of known and wealthy men.“There can be no doubt,” he says, “that were it not for the legalrestrictions as to the formation of banks for the purpose ofprotecting the monopoly of the Bank of England, numerous largeand wealthy joint stock banks would have been called intoexistence in the metropolis as well as in the provinces years ago,and would thus have prevented the establishment of those inferiorbanks, the failure of which from time to time has caused so muchdistress and ruin.”47

He asks the question why it is that whereas the public and thelegislature are content to allow free trade in deposit banking, theydid not consider it a safe practice to give permission to issue notespayable on demand. The reason the currency school usually gavefor this distinction was that bank notes increased the circulationand deposits did not. Such an argument was not, of course,acceptable to Wilson as a member of the banking school of thoughtwhich both denied that the issue of notes could be increased to anyundesirable extent so long as convertibility was strictly maintained,and pointed out that the difference claimed between notes anddeposit liabilities was invalid. But it was still denied in manyquarters that demand deposits formed part of the circulation, and itwas probably by no means generally admitted right up to the timeof MacLeod.48

The events of 1847 led Wilson to an analysis of causes ofcommercial crises. He was clear that the nature of capital implied achoice between applying labour to produce implements whichcould be used for production in the future, and applying it to theproduction of goods immediately consumable in the present. Histheory of the trade cycle is bound up with the distinction he drawsbetween fixed and floating capital.49 He was somewhat confusedabout the way in which fixed and floating capital were replacedfrom the income of the community and about the relation of allthese variables to the fund for employing labour; he was under theimpression that fixed capital is never returned.

It is rather remarkable that it should be the banking school whoshould first give support to the theory that it is the over-productionof fixed capital which leads to booms and depressions.50 A similartheory was held also by Bonamy Price, and we shall notice it yetagain when we come to the contributions made by Horn, in France.But the banking school did not, of course, connect up their theorywith inflation as the root cause: this was left for a much latermember of the currency school to do.51



From Wilson’s time onwards for more than a decade the free-banking question was dropped in England, while on the Continentit was just beginning to gather force. So we turn now to France.




CHAPTER VIII

The Discussions In France And BelgiumAt about the time when the issue in England had already beendecided and the discussion had practically ceased, the controversywas just beginning to take shape in France. The slow developmentof banking facilities in France, particularly as compared withAmerica, was first given literary emphasis by Michel Chevalier,1who was travelling in America between 1833 and 1835, just at atime when the whole banking question was foremost in the publicmind in that country. Chevalier himself upheld the retention of theUnited States Bank, and suggested that France would greatlybenefit by adopting a system of banks linked together like thetwenty-five branches of the Bank of the United States.2 Chevalier’sremarks on the backward state of French banking were endorsedalso by Carey, who testified to the beneficial effects of freecompetition. But an exactly opposite impression of the effects offreedom was created in France by Condy Raguet, and thetranslator3 of his book invoked it in evidence of the evils that werewrought by competition in banking and of the superiority of arestrictive system like that of France.

All attempts at this time to state the rationale of the monopoly inthe note issue had recourse to the State’s exclusive right to thecoining of money. This was an attitude taken up by Cieszkowski in abook4 purporting to deal with the theory of money and credit, butcontaining, in fact, very little material of theoretical value. Non-note-issuing banks may, he says, be left free from legislativeinterference, but the right to issue notes is the right to coin moneyand must be either exercised or controlled by the State. Thereasons he gives are almost purely juristic.5 This appeal to theroyal prerogative was to remain for many years the chief argumentof the restrictionist school in France.

The agitation for greater freedom in the banking trade began witha pamphlet written by Courcelle-Seneuil in 1840.6 The discussionbecame more important after the presentation of the report to theSenate in that same year on the project for the renewal of theprivilege of the Bank of France and the debates on this report. Therapporteur, Rossi, gave a very gloomy picture of the effects ofcompetition in the issue of paper money, and denied emphaticallythat there was any similarity between the application of free tradeto industry and its application to the issue of bank notes. He gavehis support to the retention of the old system of a single bank for



each locality,7 claiming at the same time that this was the only wayof overcoming the French public’s “bank shyness.”

After this the free-banking party became more prominent.Coquelin, one of the leading members of the free trade associationand an economist of some repute at that time in France, wroteseveral articles8 in its support and followed them up by a book.9His argument was based largely on the theory that economic crisesare caused by restrictions on the investment of funds in bankcapital, an argument to which we have referred already inconnection with Carey. A more general and comprehensivestatement of the case came from Courcelle-Seneuil,10 whose ideashad been much influenced by the writings of James Wilson. He triesto justify his conclusions in favour of free banking by an attempt toshow that over-issues of notes are not the cause of crises,11 andthat if banks make mistakes, it is never in their issues but always intheir investments. He was in favour of absolute freedom andunlimited competition and was the most uncompromising of all thefree bankers in France. The sole permissible regulation, in his view,was one aimed simply at the prevention of fraud. The distinctionmade between deposit banks and note-issuing banks, by whichfreedom was tolerated for the former but denied to the latter, was,in his opinion, all the more absurd when regard was had to the factthat the deposit liabilities of any bank are usually less widelyspread over large numbers of people than its note liabilities; thefailure to repay deposits might cause more harm than the failure tocash notes, because default in paying back deposits was likely tobring complete ruin to several families, whereas in the case ofnotes the loss would be distributed among large numbers of people.

The free-banking position was also supported by Du Puynode,another adherent of the trade cycle theory of Carey and Coquelin.In common with the majority of the free bankers in France hefavoured the allowance of limited liability. He looked upon theunlimited liability provisions of the English law as the chief fault ofthe English banking system, claiming that they had actually causedthe total security given by the shareholders to the note-holders anddepositors to be smaller than it would be under limited liability.12

Interest in the subject was greatly increased when the Bank ofFrance raised the rate of discount early in 1857, and the discussionwas soon attracting the attention of most of the better-knownwriters on economic subjects of the day. The circle which itinterested was much wider than in England, where exceedingly fewof the academic economists touched on the subject. In France itwas, among economists, the leading controversy of the time. In1857 it was taken up by the Société d’Economie Politique, at whosemeetings both the general question of the limitation of note



issues,13 and the specific subject of “La Liberté des Banques,”14were debated among a group which included Wolowski, Chevalier,Horn, Joseph Garnier, Courcelle-Seneuil, Paul Coq and Léonce deLavergne.

Garnier spoke against all intervention of authority and alladministrative supervision in banking, but Chevalier was not sounreservedly in favour of entirely withdrawing all intervention. Hedeclared that he was not prepared to go so far as to demand arégime of complete liberty for institutions of issue and credit, andthis was regarded by the restrictionist school as an importantadmission from one of the promoters of free trade in France.15

The next important contributions were called out in response to thepropaganda writings of anonymous pamphleteers16 in connectionwith the Bank of Savoy affair and the attack on the Bank ofFrance,17 and by 1864 the controversy was at its height.

The counter-attack on the pamphlets and on the general questionof plurality, even of the most restricted variety, was opened byVictor Bonnet.18 Generalising from the case of the olddepartmental banking system he concluded that if there are anumber of banks, the notes of each bank do not circulate beyond acertain locality. Anybody who wants to make payment in anotherlocality has to procure notes issued by a bank in that locality andhas therefore to submit to the same inconveniences and extratrouble as he does in buying foreign exchange to make payments toanother country. The advantage of having a single note issuer isthat all this is avoided, because the notes of this issuer circulateeverywhere within the country. Bonnet gave this as the reason whythe people had been far more willing to accept notes, and the totalcirculation had extended, since the suppression of thedepartmental banks. This argument against a plural system wasreally quite valueless, because it ignores the circumstance that thedepartmental banks had been deprived by law of all the normalmechanisms for the interchange of notes. He repeated also theargument used in England after the crisis of 1825 that if there areseveral banks, the solidarity of one tends to depend on that of theothers, and if there is a run on one, the others will also be affectedto a greater or lesser degree; if, on the contrary, there is one banklike the Bank of France, the public has much more confidence in it,panics are avoided and the whole credit system is thereby renderedmore stable.

On the other side, the attack on the Bank of France was resumedby Isaac Pereire.19 He denounced the policy of raising the rate ofdiscount as a means of protecting the metallic reserves andsuggested that the proper method of procedure was first for the



bank to realise its capital, and then if the effect of doing this wereinsufficient, to augment its capital; the resources obtained wouldenable it to buy the gold necessary for the specie reserve. Hedenied, in the second place,20 that there was any necessity for theBank of France to raise her rate when a neighbouring country (e.g.,England) did the same. In his opinion the rate of discount should beinvariable at 3 percent.21 Much the same attitude was taken byMaurice Aubry,22 a Paris banker. There is no better example thanthis book of Aubry’s of the influence active ever since the time ofNapoleon,23 not only in France but also in Germany, of the doctrinethat the chief function of banks of issue is to keep the rate ofdiscount down, a doctrine which, when adopted as a rule of bankpolicy, was bound to lead to credit inflations. Aubry bases his attackon the Bank of France on the grounds that the privilege of noteissue was given to the bank solely in order to favour cheapdiscount,24 and it was therefore highly improper for it to charge ahigh rate; and in this respect it was in an entirely different positionfrom that of the Bank of England, since whereas the latter mightlegitimately use the rate of discount to control movements ofspecie, the Bank of France could not do so because it was itsdeclared duty to keep the rate of interest low.25 So he, also,recommends an alternative policy of calling on the shareholders tosupply additional capital in times of crisis and paying it back assoon as there is no further need for it.26

Pereire was by no means in favour of general freedom of entry intothe note-issuing business.27 He limited his demands to one rivalestablishment to break the monopoly of the Bank of France,28 thesubstitution of a duopoly for a monopoly.

Aubry wanted the monopoly retained, and seemingly for no betterreason than that the coining of money, and therefore the issue ofbank-notes, was a royal prerogative,29 a proposition that was,according to him, one of the fundamental axioms of politicaleconomy. It was pointed out a little later by Etienne Duran30 that itwas as a result of the application of the royal prerogative to theissue of paper money that most countries had had their most fatalexperiences of paper money, and it was a grave mistake toreproach free banking with the errors of which the royalprerogative had been the sole cause.

The idea of free banking had raised in many people’s minds thevision of anybody and everybody becoming note issuers, and theysaw insuperable difficulties in the circulation of the notes ofinnumerable bankers and feared that unsound firms would have apositive encouragement to set up under the shadow of themultiplicity of different notes, and the practical impossibility of thepublic being able to exercise a close scrutiny over all the notes they



accepted. It was along these lines that the case for unity in the noteissue was formulated by those among the restrictionists whosucceeded in getting away from the purely political argument ofthe royal prerogative. Thus it was argued by Adolphe d’Eichtal31that the State intervened to assure the public of guaranteesbecause the holder of a note was almost never in a position to knowthe real position of the debtor,32 and unity in the note issueavoided the inconveniences of having to examine each notecarefully to see if it was issued by a bank that was likely to be ableto pay it or by one that was not likely to be in that position.

A Belgian economist33 of the free-banking school pointed out34 inreply to this line of argument, that the danger that “men of straw”would be able to obtain acceptance for their notes was muchdiminished when it was realised that the supervision of issueswould become largely a matter for the bankers themselves. It wasnot to be expected that the public would exercise no scrutiny at all,and it was a reasonable assumption to make that the trader wouldwillingly accept the notes of his own banker and the notes of suchother banks as his own banker was also willing to receive. Thiswas, of course, only a very partial solution of that particulardifficulty which referred to the unduly heavy pressure ofinsolvencies on the small note-holder, who was unlikely to comeinto contact with the banks as a customer.

The case for competition was also taken up by Paul Coq,Mannequin and Chevalier. Paul Coq35 endorsed the views of thePereire brothers that the rate of discount charged by the Bank ofFrance had risen as soon as, and because, the destruction of thedepartmental banks had given it an unrestricted monopoly of thenote issue. Mannequin’s contribution36 was simply a defence offree banking against the allegation that it would lead to over-issueon the usual lines of the banking school, that so long as the notes“are not thrown out of the window,” but are issued only in responseto the needs of trade, they cannot be issued in excess. Chevalierwas responsible for bringing the subject to the notice of a widecircle of readers by his contributions to the newspapers, notably tothe Journal des Débats. Courcelle-Seneuil also re-expounded hisviews in the Journal des Economistes.37

A publication which provoked a good deal of discussion was anarticle by Léonce de Lavergne,38 in which he proposed to replacethe monopoly of the Bank of France not by completely freecompetition but by a limited plurality. He said it was impossible tomanage a large area from one centre as the Bank of France wastrying to do, and an adequate provision of banking offices couldbest be provided by a system of eight or ten regions, each havingits parent bank with branches. This was a plea for something



similar to the old departmental banks but without the oldrestrictions.

Probably the most influential disputants were Wolowski andChevalier, who were on opposite sides in the controversy andundertook a direct discussion and exchange of views. Wolowski hadbegun his career as a lawyer, and his arguments werecharacteristically based on juristic rather than economic reasoning.Chevalier had been in his earlier years, before going to America,associated with the Pereire brothers in the Saint-Simonianmovement. Although his arguments were much less specious thanthose of the Pereires, we find him again by their side in thisdiscussion supporting the main tenets of their position. There is nodoubt that all three carried with them in their later days the ideasof the Saint-Simonians on banking and credit. In the newlyconstructed society envisaged by the Saint-Simonians the bank wasto play a great directing and centralising role. The banks were tobe responsible for estimating the quality and quantity of the needsof the community for capital, and for this purpose there were to belarge numbers of them specialising in the separate industries andlinked up to a central bank. The outer banks were to inform thecentral bank of the circumstances of their localities and industries,and the central bank was to distribute the credits between them. Inall discussions of the plan great emphasis was placed on theimportance of credit facilities and of the wide dispersion ofagencies for the distribution of credit.39

As a member first of the Chamber of Deputies and later of theSenate, Chevalier had plenty of opportunity of attracting publicattention to his views. He adopted the attitude40 that since freetrade and all that laisser-faire principles implied was now theaccepted policy, since the era of monopolies was said to havepassed and competition was regarded as being beneficial to thecommunity, the burden of the proof of the contention that the samesystem was not applicable to banking was on those who asserted itand not on those who denied it; because on the face of it those whooppose free banking oppose also freedom to build railways, andfree exchange in general, which, as he knew, they did not do, andhe insisted that they had as yet given no sufficient reason for theattitude they took towards banking. Wolowski took up the otherside in a book41 of extensive proportions, which contained,however, no very original additions to what had already been saidon the subject. It was almost wholly a repetition of the viewsexpressed by others and a commentary on the trend of policyalready adopted in the matter. But his doctrinal importance in theFrench developments must not be under-estimated, for he stoodout among the French school as the most emphatic adherent of theuse of the rate of discount as a means of controlling specie flows.



This brings us to the eve of the French Banque Enquéte.42 Theenquiry arose out of the Bank of Savoy affair and the raising of therate of discount in 1864, and was entrusted to the Conseilsupérieur de l’agriculture du commerce et des travaux publics, ofwhich both Chevalier and d’Eichtal were members, and thereforetook part in the examination of witnesses. The report is containedin six volumes and comprises altogether close on five thousandpages. The Council called as witnesses, besides the delegates fromthe Bank of France, all those who had gained anything of areputation as writers on subjects connected with money andbanking. A number of foreign economists were also invited to statetheir views, and written memoranda were submitted by ThomsonHankey, William Newmarch, R. H. Patterson and J. S. Mill, fromEngland, Professor de Laveleye, from Belgium, and ProfessorTellkampf, from Germany. In addition, Walter Bagehot had thedistinction of being called as first witness before the Commission.Among the French witnesses some had already published theirviews (e.g. Wolowski, Isaac Pereire, Bonnet, d’Eichtal, Aubry,Lavergne, Chevalier, Courcelle-Seneull, Paul Coq), and we shallhave occasion to refer to others (Cernuschi, Coullet, and Horn),who were writing contemporaneously with the enquiry. Looked atas a whole, the evidence cannot be said to have contained anyconsiderable amount of material of value from the point of view ofmonetary theory. Chevalier made clear his views on the subject ofdiscount policy in the course of his examination of therepresentatives of the Bank of France. He doubted the utility or thenecessity of using the rate of discount or even the restriction ofcredit in general, no matter what the means, as a remedy forstopping a gold efflux.43 The policy that was, in his opinion, thecorrect one, was that of the sale of its “rentes” by the Bank,44 andhe emphasised the necessity of not immobilising the capital of thebank in quasi-irredeemable Government obligations which mightnot be available for this purpose. What Chevalier, along with theother supporters of the same policy, such as Aubry and thePereires, overlooked, was that the sale of securities by the Bankmust contract credit just as certainly as a direct contraction of theamount of bills discounted by the Bank. It would deprive the short-term loan market of the amount of funds acquired by the Bank forthe securities it sold, and so there must be a tendency for loanrates to rise. This school thought they had discovered an ingeniousdevice in the shape of an open market operation which would makethe Bank more liquid without causing stringency in the moneymarket.

More careful attention was by this time being given to thecomparative effect of the alternative systems on the total volume ofmoney and credit. Up to now the free bankers had by no meansbeen of identical opinion. Some of them had held that there was no



reason inherent in the free-banking system why its issue should bemore expansive than the issue of a central banking system. Othershad argued that a free-banking system had a positive advantage inreplacing a large part of metallic money by fiduciary money which,costing nothing, could be lent cheaply and thus favour thedevelopment of trade and industry. The ideas of this school wereopenly inflationary and provoked the attack of a number of peoplewho took up an anti-inflationist attitude.

Emile de Laveleye, a Belgian Professor of Political Economy,attacked45 the expansionist section of the free-banking school ontwo grounds. Firstly, he said that if what they claimed, namely, thatfree banking would lead to an expansion of the circulation, wastrue, this must be followed by a heavy drain on bank reserves ofspecie followed by a contraction of the circulation, and a crisis. Hepointed out that the crisis would be, moreover, of greater violenceunder a system of a large number of banks as compared with thecase of a privileged bank which, having the unlimited confidence ofthe public, could extend its issues at such times. But in the secondplace, de Laveleye argued that the free bankers might be wrong inassuming that their system would provide easier credit conditionsin the upward swing of the cycle, and that it was, on the contrary,conceivable that it would involve the keeping of larger reservesthan the present system and therefore would lead actually to asmaller circulation. He was himself willing to consider the free-banking system on condition that the banks should be subjected tothe condition of unlimited liability.

Just at this time there began an attack on bank-notes in general. Itwas opened by Cernuschi,46 who held that the vital question wasnot one of whether the note issue should be in the hands of a few orof many banks, but whether banknotes should be issued at all. Theyhad the effect of spoliating the holders of metallic money bydepreciating its value, and if they had any use at all they should bemade to represent mere certificates for gold deposited and thefiduciary or uncovered issue should cease entirely. But he joined inthe demand for free banking because he thought that if any andevery bank were allowed to issue notes, nobody would accept themany longer, and so they would disappear. The same attitude towardsthe bank-note was taken up by Modeste.47 Courcelle-Seneuil, DuPuynode and Mannequin entered the discussion on the otherside.48

Perhaps the best analysis of the point of view of the central bankingschool was that made by Coullet.49 He sets out the advantages anddisadvantages of each of the alternative systems, and decides thatthe weight of the argument is in favour of monopoly andcentralisation. He defends the distinction commonly made between



notes on the one hand, and bills of exchange and deposits on theother, because of the element of compulsion in the acceptance ofthe former and the fact that it is not the people who are enabled toborrow on easier terms and so benefit by the extension of thebanks’ issues who are likely to suffer when the notes depreciate,since the notes will by this time have passed into the hands of thirdparties.50

Coullet believed that freedom of issue would accomplish its owndestruction, and was, therefore, in a somewhat similar though notso extreme position as Cernuschi. He supposed that as the result ofthe numerous failures that were bound to occur under such asystem one of two things would happen: either the public, struck bythe contrast between the majority of the banks and a few or evenperhaps a single bank, would in future confine its dealings to theseor this bank and so there would be established a de facto monopoly,or the whole system would be afflicted and the bank-note would beabandoned altogether. If, however, it should prove possible to buildup a system of well-organised and solid banks, the result (hethought) of plurality would be not a lowering of the rate of interestbut a raising of the rate, because of the anxiety of the banks (evenin normal times) to keep adequate reserves. Even in ordinary times,and against the same total circulation, the united reserves of alarge number of banks would have to be greater than the totalreserves of a single bank. Moreover, the centralisation of reserveshad an advantage as a source of strength in periods of crisis. Theadvantages of monopoly were, in Coullet’s opinion, more thansufficient to outweigh the avowed danger of the Government’sabusing its power over the single bank of issue.

The best exposition of the free-banking case came from J. E.Horn.51 In the first place he disposed of the royal prerogativeargument in economic terms.52 While pointing out that it wasprivate industry that had first commenced the coinage of specie, hesubmitted that there were probably two reasons why it had laterbeen taken over as a State monopoly and claimed as a royal right.One was in order to facilitate the circulation of coins as a mediumof exchange over wide areas at a time when the State was the onlyinstitution that was generally enough known to inspire sufficientconfidence that the coins were what they professed to be in weightand fineness, and so to make it unnecessary to weigh and assayevery coin before accepting it. The second reason was that the Kingfound it the most convenient way of acquiring revenue. In our day,he continues, however, it is no longer necessary as a budgetarysource,53 and neither is it true any more that the State is the onlyinstitution which could provide the service of coinage. If a firm likeRothschild, in Paris, or Baring, in London, were to undertake the



stamping of coins, they would be just as willingly accepted as thecoin of the realm.

Horn, in company with Chevalier and Courcelle-Seneuil, and alsomany of the less prominent writers on free banking, denied thatbank-notes were money, and this became one of the major issuesbetween these writers and Wolowski. It was an attitude which was,of course, in many cases adopted, perhaps rather unnecessarily,merely in order to bring bank-notes outside the prerogative of theCrown in the coinage of money, and was little more than theplaying off of sophistry against sophistry. A great deal of space wasdevoted to this discussion of a matter which was, in the lastanalysis, a question of definition as to whether two things should bedenoted by the same term because they possessed a certaincharacteristic in common, or whether they should be sharplycontrasted because they differed in respect of a secondcharacteristic. Wolowski was defining bank-notes as moneybecause both bank-notes and coin exert like effects on trade andprices. Chevalier and the others were insisting on the necessity foralways regarding bank-notes as merely substitutes for, and alwaysconvertible into, coin, since any view which neglected the conditionof strict convertibility must lead to their over-issue and unlimiteddepreciation.

Turning to the positive disadvantages of a privileged monopoly,Horn called attention to the greater possibility that the liability ofsuch a bank to pay out specie on demand would be revoked with itsconsequence of pure paper money in place of notes convertible intocoin. A bank under State patronage always counted on theGovernment to relieve it of its obligation to pay when nearinginsolvency, and its bankruptcy became legalised instead of itshaving to go into liquidation and suffer the usual penalties ofinsolvency. The history of privileged banks had undeniably been fullof bankruptcies. If banks of issue were given to understand,however, that they were positively and irremediably responsible fortheir acts, and had themselves to bear the consequences, theywould be as prudent in their policy as any other businessconcern.54 There was also, as Chevalier55 had alreadyemphasised, the ever-present temptation for the Government toabuse its power over the privileged bank.

There can be no guarantee that failures will never occur undereither system, but in the case of a plural system only the notes ofthe failed firms depreciate, whereas in the case of a privilegedmonopoly the legalised suspension, and therefore the depreciation,affects the whole of the note issue. Moreover, if banks temporarilysuspended payments under a free system, the competition of banksstill maintaining cash payments would wipe them out of business if



they did not hasten to resume payments, and suspensions wouldtherefore be of shorter duration.

Banking freedom in the true sense of the word, and the systemwhich Horn favoured, was a system in which companies would beallowed to set up in the banking business, whether issue, discountor deposit, under just the same regulations as those under whichcompanies were allowed to set up, in other industries,56regulations which concentrated on the prevention of fraud. But hepermitted that it was not unreasonable that people should want toadd to these stipulations some others specially relating tocompanies undertaking the issue of notes,57 because of thecircumstance that, in addition to the shareholders and the peoplewho contract with the company, there is a third class involved,namely, the indirect and to a certain extent involuntary acceptors ofbank-notes, and it was on these grounds that he thought the 1863legislation of the United States was admissible. Such regulations,however, he still regarded as not entirely indispensable.

In sympathy with the tradition of the banking school, Horn was ofthe opinion that a crisis could never be caused by an over-issue ofnotes, since no more would get into circulation than just sufficed tosatisfy a genuine demand. Banks, therefore, made mistakes not inthe quantity of their issues but in the lines in which they made theirinvestments, and crises were caused according to him by a scarcityof circulating capital. In periods of “over-investment” too muchcirculating capital is transformed into fixed capital until it isdiscovered that there is an insufficiency of the auxiliary materialsnecessary to co-operate with it.58

The direct discussion between Wolowski and Chevalier continuedfor some years, and the correspondence was published by Wolowskiin his later book.59 Courcelle-Seneuil also made another finalstatement of his position,60 again pointing out the extreme lack ofbanking facilities in the provinces in general, and of agriculturalcredit in particular. Neither Courcelle-Seneuil nor Horn was amember of that group of free bankers who supported their casebecause they expected it to increase the possibilities of expansionand the lowering of the rate of interest. Courcelle-Seneuil did notregard it as certain that issues would be greater under competition,nor that the rate of interest would be lowered, and in so far as thelatter was at all likely he thought it would come, not by way ofincreased issues, but by way of the collection and utilisation of idlesavings. He was the most unyielding of all the free bankers,insisting on complete liberty as understood in other branches oftrade and industry. He refused to consider the application of anyspecial regulations to the case of banking, and emphatically deniedthe favourite contention of the restrictionists61 that banking firms,



unlike those in other industries, cannot be made to bear themselvesthe consequences of their mistakes.

It will be remembered that in England, prior to 1844, it had been aconstantly recurring complaint that the efforts of the Bank ofEngland to contract credit in time of a specie outflow were alwaysrendered nugatory by the failure of the country banks to do thesame, and it was held up against the free note-issuing rights ofthese banks that they were insensitive to the foreign exchanges.This same argument was re-introduced in a slightly moresophisticated form by Clement Juglar.62 He used it in favour of acertain type of centralisation. His argument ran that there was apractical difficulty in a plural system in distributing the demandsfor specie to send abroad because the settlement of commercialoperations with foreign centres tends to concentrate in the largetowns and the demands for specie will fall on the banks in theseplaces, while others are unaffected by the drain on reserves andhave no incentive to check their issues. From this he drew theinference that the best system would certainly be one that was freeand competitive in the sense that there should be a large number ofbanks spread over all localities, but that it should be controlledfrom the centre by the Bank of France acting as a clearing-house.The chief purpose of his central bank was to render the banks lyingoutside the trading centres sensitive to the forces necessitating acontraction of the currency by facilitating clearing operations. Butit is extremely doubtful whether any such externally imposedinstitution as the Bank of France or any other is necessary to effectthese operations. With reasonable communications and noartificially imposed obstacles, clearing arrangements will be madeby the banks themselves. Thus, if one group of banks (A) near theports or in Paris is affected directly by gold withdrawals for exportand contracts its note issue, but another group (B) is not soaffected, group A will have less notes in circulation in proportion tothe circulation of B than it did before; the clearing balances will goin favour of A, who will consequently acquire claims on the goldreserves of B. This will constrain B to contract its liabilities and sothe contraction will be diffused throughout the whole system. Thedifficulty raised by Juglar to a position of such primary importancewas imaginary rather than real and would certainly not in itselfprovide the sole reason for the existence of institutions endowedwith such privileges and position of ascendancy as the Bank ofFrance. Juglar was really advocating a mixed system in whichrights of issue should be given to the competitive banks, but inwhich there should be a central bank with a controlling influence,something between free banking in the pure sense and the singleprivileged monopoly system in vogue in France.



What is the connection between the free-banking school and thebanking school, on the one hand, and between the central bankingschool and the currency school on the other? It is not unnatural toexpect it to be very close in both cases. It is especially noticeable inFrance that most of the free bankers were adherents of the bankingtheory which denied that bank-notes could be over-issued so longas convertibility was maintained. Brasseur, Horn, Courcelle-Seneuil, Coq and Mannequin were among the most convinced ofthe banking theorists. Cernuschi was an exception. He was amember of the strictest section of the currency school whichbelieved not merely that the fiduciary issue should be fixed, andany issue above this limit covered by metal, but that there shouldbe no fiduciary circulation at all. He supported free banking,however, for the peculiar reason, as we have already explained,that he thought such a system would destroy the note issuealtogether.

Adherence to the tenets of the central banking schoolcorrespondingly usually carried with it the support of the principlesof the currency school. The exception in this case was Coullet, whoopposed the fixing of any limits on the fiduciary issue so long asthere was only one bank of issue.

Among those who opposed the unlimited right of issue of the Bankof France there began at this time a discussion of the relativemerits of the fixed fiduciary issue and the fixed reserve proportion.The latter was a rather less rigid interpretation of the currencydoctrine. Wolowski was a great admirer of Peel’s Act, andCernuschi also preferred this to the reserve proportion method ofcontrolling issues for the reason that the latter tended to causegreater embarrassment in time of specie withdrawals, but Léoncede Lavergne and Adolphe d’Eichtal both favoured the secondmethod.

By the beginning of the ‘seventies the attention of monetarytheorists had been turned to the bi-metallic question. Wolowski andCernuschi both figured among the supporters of the retention ofthe double standard.




CHAPTER IX

The Discussions In GermanyIn Germany the question of banking freedom came to the forefrontof discussion later even than in France. An early book that hadsome considerable influence was the account given by F. A. vonGerstner1 of the impressions he gathered when travelling inAmerica, and in which he attributed the swift development ofAmerican industry and commerce to the banks.2 He wasresponsible for arousing a good deal of false optimism as to theeffects of credit expansion, and led some readers to believe thatbanks were vested with a kind of magic power.

It was not until the ‘fifties that any modern literature on bankingand currency of any importance was written, and then within a fewyears three writers came into the foreground—Otto Hübner, J. L.Tellkampf and Adolf Wagner. The first of these, Hübner, was anactive member of the German Free Trade Party. His book3consisted for the most part of a survey, largely historical andstatistical, of the chief banking institutions then in existence allover the world. His general conclusions were strongly in support offree banking. Practical experience had shown, he said, that bankswere least often insolvent where they were least restricted.4 Statesnever gave privileges without demanding a quid pro quo, and ifbanks wanted to keep their privileges they had got to fulfil thewishes of the Government. “For exclusively privileged banks,” hesaid, “insolvency is as a rule the entrepreneur’s best speculation”;foremost in his mind was the case of the Austrian National Bank;without declaring itself insolvent it could never have lent suchlarge sums to the Government, but if it had not lent theGovernment what it did, its profits would have been much smaller.5The contrast is between privileged banks which are protected bythe law from the consequences of their mistakes (if they shouldbecome insolvent, the Government gives forced currency to theirnotes) and the free-banking system where the bankers must bearthe results of their own acts. Moreover, the mere fact that the Statesupports a privileged bank gives it an unwarranted trust.

Hübner did not base his case for free banking on the theories of thebanking school—on the contrary: he was the first of a group thatbecame rather fashionable in Germany, that held that only so manynotes should be issued as there was metal to back them.6 The rulewas that banks should not lend more than they receive. It followedthat Hübner was also not a member of that division of the free-



banking school which looked upon free banking as a means oflowering interest rates. If such a lowering of interest rates were toaccompany an increase in the circulation, it would, he said, be anexpression of the unhealthiness which such an increase produces.7If it were true that the State could be trusted always only to issuenotes to the amount of its specie holdings, a State-controlled noteissue would be the best system,8 but as things were, a far nearerapproach to the ideal system was to be expected from free banks,who for reasons of self-interest would aim at the fulfilment of theirobligations.

The same rigid interpretation of the currency doctrine found asecond supporter in Tellkampf. In his earlier years he had travelledin America, and it was his observations of the abuses of thebanking system in that country which were supposed to have ledhim to his conclusions that the amount of paper should beregulated strictly by the amount of specie deposited in exchangeand that the issues should be in the hands of a single bank. He hadpublished these views in America as early as 1842,9 but they didnot at that time attract much attention. Having returned toGermany he became Professor of Political Economy at Breslau andwas also elected to membership of the Prussian Senate, where hetook a leading part in the discussions on bank legislation. One ofthe points with which he was concerned in his first book10 was tocombat the idea still pervading some circles in Germany thatbanking possessed the power to effect unlimited increases in realwealth.11 On the question of freedom he drew a sharp distinctionbetween note-issuing and deposit banking. It was, in his view,impossible to allow the former to be carried on by all privatepersons without legal limitation, but he makes an exception to thisrule under two conditions. Firstly, the issuers must be subjected tounlimited liability. Limited liability was, he contended, not a rightthat could be demanded in the name of free trade but a privilege bythe granting of which the State had undermined the naturalprinciple of responsibility underlying free trade. Secondly, the noteissuers must be free from all obligation to lend to the State.

While Tellkampf looked to centralisation of the note issue as theultimate end to be sought,12 there was at this time in Prussia noprospect of attaining any effective unity in the note issue, and theincrease in the number of banks and their unlimited issues in the“Border States” led him to favour Prussia’s setting up her ownprivate banks so as to keep out the notes of these other States. Herecommended that these new banks should be set up on the Scotchmodel,13 on the principle that if the shareholders were liable fortheir obligations to the full extent of their property, self-interestwould provide the necessary limitation on note issues.14



By far the best known among the German economists of hisgeneration was Adolf Wagner. As strictly as Tellkampf was afollower of the currency tradition, Wagner was an adherent of thebanking school. Writing at a time when the currency doctrine wasbecoming very powerful on the Continent, he set out in this firstbook15 to do two things: The one was to explain the disadvantagesfrom the economic point of view of the ruling system of privilegedbanks, and the other to examine the basis of Peel’s Act. He hadmade a very close study of English literature on this and alliedsubjects and had been especially influenced by the writings ofJames Wilson. It was through Wagner that the chief accusationsthat had already been made in England against Peel’s Act and thecurrency doctrine were made available to German readers. His ownopinion was that banks should be allowed to set up without legalhindrance, and he opposed the statutory fixing of note issues or ofreserve proportions, thus fully supporting the free-bankingposition. Peel’s Act he regarded as being unsound, not only becauseit was based on the mistaken theories of the currency school, butalso on the additional ground that the Bank of England had throughits privileged position acquired a responsibility to render aid duringa crisis by liberal lending, and now Peel’s Act had left its privilegesintact but had taken away its obligations.16 The defect in thesystem of the great privileged central banks to which he gave mostweight was the misuse the Government makes of the power itexercises over such a bank by encouraging it to discount toocheaply and to invest in too much State paper.17 While the Pereiregroup in France had assessed the fault of a single privilegedcentral bank to be one of keeping discount rates too high, Wagnerheld it to be the opposite of keeping lending rates too low.

In the more detailed criticism of the currency doctrine which hepublished a few years later,18 prominence was first given inGermany to the theory of “bankmässige” cover. This was closelyconnected up with the celebrated principle of the automatic refluxof notes. The theory was that so long as notes were lent out in truebanking business, that is short-term assets, they came back in thenatural course of business after the elapse of the loan period andthe amount of the issue was supposed for this reason to beconstantly subject to check. From this time onwards “bankmässige”cover assumed a position of considerable importance in Germanbanking discussions and legislation.

The most interesting treatment of the proposals for free banking inGermany is contained in the discussions of the Congress of theDeutsche Volkswirte19 in the early ‘sixties and the separatewritings of one of its most prominent members, Otto Michaelis. TheCongress set out to formulate a legal framework for free banking.It decided that provided unlimited liability were imposed on



banking companies, special legal conditions were unnecessary. Iflimited liability were the rule, however, it might be necessary toformulate certain legal requirements (Normativbestimmungen). Asto what exactly these conditions should consist of was a matter ofsome considerable debate, and full agreement was not reached onevery point. All the speakers seem to have agreed that no fixedlimit should be put on the note issue and that no stipulated reserveproportion should be imposed. They were not quite unanimous onthe question whether only certain specified types of assets shouldbe permitted for use as note cover. Max Wirth was of the opinionthat all notes should be covered by metal plus “bankmässige” bills.He regarded both Government as well as other long-term securitiesas being too unstable in value to be good note cover.20 Michaelisthought that neither lombard loans nor State paper were propercover for notes, and the New York bond deposit system was on thisaccount indefensible. But although he accordingly believed that itwas good counsel to recommend to a bank that notes should becovered by “bankmässige” bills, he considered that it was notnecessary to lay this down as a legislative condition. The Congresswas not for the most part in favour of stipulating that billsdiscounted by a note-issuing bank must have at least two names.Neither did such measures as the placing of restrictions on theamount or type of business other than note issue, legal provisionsfor the cover of deposits, limitations on the amount of depositliabilities, or special requirements as to the period of notice forwithdrawal of deposits, receive any support. It thus rejected all thePrussian “Normativbedingungen” as inappropriate.

The question whether note-holders should be given preferentialrights over other creditors (depositors) in the event of a liquidationwas answered in the negative. Great importance was attached byall the speakers to the point that the bank should always be obligedto cash notes on the day of presentation on pain of liquidation.21This emphasis on the necessity for the rigid enforcement of theliquidation penalty for a failure to meet obligations was somethingof a departure from what had been customary in the past.Observations had from time to time been made on the need for theenforcement of quick resumptions of payments, for the impositionof penalties varying with the length of time for which thesuspension lasted, and for liquidation after a more or less lengthyperiod, but it was usually taken for granted that a suspension for acertain length of time was permissible and normal.

Particular emphasis was placed by Michaelis, and the Congress asa whole, on the, up till now, neglected importance of depositbanking, and the Congress resolved that the setting up of discountand deposit banks should be recommended,22 and when it againapproached the subject two years later,23 Michaelis was very much



in favour of making the campaign for the development of bankingindependent of the fight for freedom in note-issuing, because herecognised how remote were the chances of success of the latter.This was in spite of his being in sharp disagreement so far as thetheory of the subject was concerned with the common view thatnotes and deposits were to be rigidly contrasted.

In an article published in 1865,24 Michaelis argued that byestablishing unity in the note issue, one of the most importantchecks on over-expansion was removed. With a large number ofbanks the average period of circulation of notes was shortened;each note had more chance of coming back to the issuer for cashpayment. Now in the case of deposit credits, he says, the limits toexpansion are even narrower. The test of cashability comes veryearly; a check is not likely to change hands many times byendorsement and will often be paid in immediately to his bank bythe person in whose favour it is drawn. Every check drawn infavour of someone outside the circle of customers of that bank onwhich it is drawn will be paid in at another bank, thus giving thelatter a claim on the former, and unless it is balanced by acounterclaim, the one will lose cash to the other. While admitting tothis extent a certain difference between checks and notes (thelatter were likely to remain for a longer average period incirculation outside the banks before being paid in), and this wasthe only distinction of any importance that had yet beenrecognised, Michaelis did not see in it sufficient reason forwithholding freedom from the note-issuing business while allowingit to deposit banking. In both cases, so long as there were a numberof banks, a strict control would be exercised by and among thebanks themselves. In both cases monopoly increased the circulationperiod and deferred the test of cashability.

Michaelis was convinced that there exists in a multiple bankingsystem an automatic mechanism which checks any tendencies toexpansion of the note issue. And this, he said, will work so long asthere are some or even one of the banks that does not expand.25He thus regards it not only as a means of checking any single bankgetting out of step with the rest, but as a mechanism which, sincenot all banks without any exception are likely to set the process ofexpansion going at the same time, will keep the whole systemunder control. Longfield’s objection would, if it is valid, apply afortiori to this case, but it remained more or less unknown.

To those who argued in favour of unity because it widened the areaover which the notes of any bank could be used, Michaelis repliedthat it was a positive advantage from the point of view of limitingthe note issue if the territorial area of circulation of the notes of



any bank were small, since it made their return to the issuer morefrequent.26

It was at about this time that the first publication27 appeared of awriter who has, perhaps, received far less attention than his workmerited. We refer to Philip Joseph Geyer. He was, in common withTellkampf, an adherent of the stricter form of the currency theory.He started off from the thesis that the amount of money incirculation should always remain constant,28 and that themovement away from an approximation to such a state of affairshad been caused by the issue of bank notes not covered by specie.He held that only fully-covered note issues are a “real” economicfactor, uncovered note issues merely bring “artificial” capital(künstliches Kapital) into operation, and if more artificial capitalcomes forward than there is real (natürliches) capital lying idle, acrisis results from the phenomenon of overproduction.29 Whilebeing violently opposed to freedom of note issue, he was very muchin favour of giving freedom to set up deposit banks which wouldcollect and use the idle real savings. He speaks of such a processmaking the uncovered note issue unnecessary.

After the crisis of 1857 and the operations as lender of last resortthen carried out by the Bank of England, there had been noticeableeven in Germany something of a change of emphasis in thearguments for central banking. The advocates of a strong centralbank ceased to support it merely because they thought it was theonly way of keeping note issues within the necessary bounds andincreased the emphasis on panic financiering. This attitude wasclearly stated by Professor Nasse in a pamphlet he published earlyin 1866.30 Whereas small note issuers were always discreditedduring a crisis, the notes of a central bank could continue to satisfythe internal currency demands. Therefore, by avoiding thenecessity of providing for an internal drain of metal on top of theexternal drain, central banking rendered the crisis less serious. Forthese reasons Nasse welcomed the idea of the Prussian Bankbecoming a central bank and opposed Peel’s Act, which takes fromsuch a bank the possibility of filling up the gaps made in the creditsystem of a country by a crisis. His attack on the principle of Peel’sAct was directed against a Bill just introduced into the Prussianlegislature by Michaelis for the fixing of the fiduciary issue of thePrussian Bank.

It would at first sight seem a little strange that such a Bill shouldbe sponsored by Michaelis, who had always been in favour of thefullest freedom for note-issuing banks and a minimum of legislativeinterference. His attitude is, however, perfectly consistent with hisgeneral thesis. Where there are a large number of banks, there isan automatic check on the note issue; in the case of a privileged



monopoly this mechanism is absent and therefore some externallimit must be imposed.31

Nasse agreed with Michaelis that note cover should as far aspossible be kept “bankmässige” (short-term commitments). Thisexcluded Government securities and was in direct opposition to thebasis of Peel’s Act, under which the fiduciary issue could be backedonly by Government securities.32

Geyer and Tellkampf both elaborated their views further in 1867.33Geyer summarises the faults of the present banking system undertwo heads: first, that it provides the material for trade crises andproduction cycles by producing “artificial capital” up to a pointwhere there is an excessive amount of capital in existence, and,secondly, that having produced the crisis, it intensifies it bycontracting credit and causing forced sales. His explanation of theoriginal of the boom came very close to the modern “over-investment” theories of the Austrian school, but he failed to giveany acceptable explanation of the more immediate cause of thecrisis and depression. His reasoning here develops into an under-consumption theory. The over-supply of capital results in the over-production of consumption goods, which he believes cannot beabsorbed by the market, because the demand for consumptiongoods will only increase with a fall in their price, and while it istrue that cheaper capital reduces interest charges, this is so smallan item as to be hardly perceptible in the final price of goods readyfor consumption.

He approaches the theory of banking somewhat along the lines ofthe modern theory of the equation between investment and realsavings. The difficulties which accompany the solution of the bankquestion lie not so much in the theory, he says, as in the practice.34The theory is clear, that the uncovered note issue should bebrought into equilibrium with the amount of capital lying idle, butas we do not know the amount of this idle capital, it is impossible toeffect an equilibrium. He concluded that it is advisable to give upaltogether the issue of uncovered notes and that the idle capitalcould better be collected by extending deposit banking. In theperiod of change-over, the reduction of artificial bank money shouldfollow in step with the increase in deposits, and to accomplish thisit is necessary that the note issue should be centralised andconfined to a single institution. He realised that even given thisunity in the note issue there would still be internationalcomplications; it would be pointless as well as difficult for any onecountry in isolation to give up “artificial bank capital,” since itwould be affected by the creation of bank capital in other countriesand would probably be unable to hold out against the lowerdiscount rates elsewhere.



Peel’s Act was not a commendable solution to Geyer’s problembecause it did not carry the currency principle to its logicalconclusion. It should either forbid uncovered notes altogether orelse arrange that they should be equal to the idle money capital.Since it did neither of these things it could not prevent crises, andonce crises arose, it led to further complications by provokingpanics instead of easing credit conditions so as to reduce tradelosses.

The attitude taken up by both Geyer and Tellkampf in demandingthe total abolition of the fiduciary issue ignored several importantaspects of the monetary problem. Starting, as they do, from asituation where the existing money supply already contains notes inlarge proportion not covered 100 percent by metal, theyunderestimate the difficulties of the deflationary process whichwould be involved in getting back to their “ideal” situation, andwhich would entail a much more violent and lasting disturbancethan any which was likely to occur from the movement they fear inthe opposite direction. And, what is more important, perhaps, theobjective would have no real value, since there is no specialsanctity of any specific figure for the total quantity of money. Allthat is important are fluctuations in this total quantity, and all thatGeyer’s theory required was that no further increases should takeplace, so that the economic system, once having got intoequilibrium with the amount of money in existence at the moment,will not be required to readjust repeatedly in the future.

In confining their considerations to bank-notes and the effect ofthese on the total quantity of money, they ignore also complicationsintroduced by the existence of demand deposits and the effects ofchanges in their velocity. We start from a position where we have avolume of demand deposits which have arisen, not (or not all) frompayments into the banks of an equivalent amount of cash, but fromthe redeposit of loans (also not backed 100 percent by cash) madepreviously by the banks, and these demand deposits alter thevolume of effective circulating media of exchange by changes intheir velocity of circulation (number of checks drawn per period oftime).

The criterion of keeping the amount of the circulation constant mayat times, then, positively require the amount of currency in theform of bank-notes to increase. Such would, for instance, be thecase where a decline in the activity of deposits (increase in theaverage period for which they remain idle) requires the banks tomake fresh loans if they are to keep the effective circulation thesame as it was before, and the new borrowers prefer bank-notes todemand deposits. Once the deposits have been created, it isimmaterial so far as the economic results are concerned what part



of them is changed into currency, and the only deciding factorwould seem to be the choice of the public as to which they prefer,deposits on current account or bank-notes.

The less extreme currency school writers, as well as the bankingschool, regarded notes as rendering a service in what they called“economising specie,” which is usually to be interpreted as“providing easier credit.” Geyer and Tellkampf, adherents of thevery strictest currency doctrine, look upon them only as a moreconvenient form in which money can be carried about ortransported. It is noticeable also that where people like Tooke andWagner saw as the sole evil of increasing the amount of currencythe possibility that it might depreciate its value (raise the pricelevel), and therefore concluded, that since an increase in its volumehad frequently taken place without causing a decrease in itspurchasing power, it was not always an evil,35 Geyer did at leastsee that changes in the quantity of circulating media producedchanges in the structure of production with certain undesirablerepercussions.

In his later work Tellkampf still considered that if the plan ofunifying the note issue and restricting it to the amount of speciedeposited could not be put into operation, then the next bestalternative was the Scotch system, and he seems to have regardedthis as a very good second best.

The discussions conclude in Germany with a few publications at thebeginning of the ‘seventies, just prior to the foundation of theReichsbank. Among these was a pamphlet by Leopold Lasker,36who alleged, probably not unjustifiably,27 that it had still not beenconclusively shown why banking should be made the exceptionfrom the rule of private enterprise in all branches of economic life,and that no case had yet been made out against “Bankfreiheit.”Two treatises on banking and credit were also published in theseyears by Wagner and Knies38 respectively. These two weresupporters of opposite sides in the controversy, but Wagner had bynow obviously come under the influence of the historical school andtherefore was no longer so uncompromisingly in favour of the free-banking system, and insisted that there could be no absolutesolution in favour of one system; all systems can be justified in theappropriate circumstances. He had, however, abandoned few of theessentials of his old position, and the bias is still towards the free-banking ideal.

One of the theories he sought to destroy was the idea that note-issuing brought in a fabulous profit. This idea was one of thegrounds of objection to free banking held by Knies, who wrote thatthe creation of bank-notes must be subject to special regulations,39



because their creation was costless. Wagner pointed out theexistence of costs of management, and especially the costs of thesubstantial capital that was necessary for a note-issuing business.

Neither did Wagner admit that it was necessary to single outbanking from among all other branches of industrial activity andsubject it to unlimited liability provisions. But he allowed that itmight be an advantage to reform the whole of the company law soas to enforce special requirements for different types ofundertaking, and with this idea in mind he set out to formulate the“Normativbedingungen” that might be applied to the case ofbanking. Accordingly, he suggested that the bank’s capital shouldbe required to attain a certain figure, that there should be a limiton the lowest denomination for notes, that there should be aregular exchange of notes once or twice a week between banks,and that the principle of publicity should be enforced. Suchregulations as these he regarded as being perfectly compatiblewith the idea of full “Bankfreiheit.” Other clauses frequently to befound in bank laws, such as regulated the business of the banks,fixed the relation between the amount of the note issue and theamount of the bank’s capital or determined the form of the notecover, were not compatible with full “Bankfreiheit,” but if complete“Bankfreiheit” was looked upon with suspicion, some clauses of thiskind might be conceded.

In common with Michaelis, he placed emphasis on the necessity fora speedy liquidation of insolvent banks. If a note when presentedfor redemption is not paid at the bank’s chief place of business orat its redemption counters and branches, and within a shortperiod—three days is the time he suggests—the bank can still notpay its obligations, any creditor of the bank should be allowed tobring a demand before the courts for its liquidation. The onlyextenuating circumstances should be cases of forces majeures,such as a foreign invasion.40

Wagner took sides against Michaelis on the question of whether,once it was decided to impose reserve requirements for the noteissue, it was better to use the Continental or German method(“Dritteldeckung,” or one-third specie cover) or the Peel system(fixed fiduciary issue). Knies and Michaelis both favoured the Peelsystem. Wagner preferred the “Dritteldeckung,” because, althoughit was true that the figure of one-third was purely arbitrary, it is farless rigid than the Peel system or the American bond depositsystem.

Commenting on the 1866 experiences in Germany, which hadturned the thoughts of many people towards a consideration andaffirmation of the advantages of a central bank, Wagner agrees that



it had evidenced advantages. He submits, however, that they werenot necessarily such as could only be gained by privileged orentirely monopolistic central banks, and that not only the PrussianBank but also similar great banks in important cities such as theFrankfurt, Leipzig and Bremen banks, smaller central banks orcentral banks of second order as they might be called, had givensupport to reputable firms at the height of the crisis.41

The partial recantation of Wagner, the once relentless champion ofBankfreiheit, may be fairly regarded as the end of the activeopposition to central banking in Germany.


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CHAPTER X

The Post-1848 Discussions In EnglandThe account we have so far given of the development of Englishthought on the merits and demerits of a free-banking system, ascompared with one in which the note issue was monopolised,brought us up to James Wilson’s contribution at the close of the‘forties. In England, at least after 1844, if not before, the onlypractical problem was always whether, given central banking, thereshould be limitations or no limitations on the amount of the notecirculation. The question of whether there should be freedom orprivilege in the issue of notes was scarcely ever raised. But thediscussion of its latter problem on a much more extensive scale bythe economists and financial experts on the Continent could not failentirely to draw the attention of their English contemporaries.

The economic literature of the ‘fifties in England showed an almostcomplete neglect of this problem: there were not many more than acouple of references to it. Of these one was due to R. H. Mills,professor in one of the Irish Universities, who treated the subject inthe course of a series of lectures which were later published.1 Inhis view, “a violent expansion and contraction of the currency... isthe inevitable result of a system which has still many advocates andwhich has but late been checked... that of allowing a number ofbanks of issue to subsist in the country.”2 In support of thisstatement he quotes verbatim the argument given by Longfield,and this citation appears to be right up to the present day3 the onlyinstance of any mention of Longfield’s point, in spite of its beingthe most important single controversial point in the theory of theproblem.

The other reference to which we have referred came from the penof Herbert Spencer,4 and is a denunciation of all State interferencein banking and a plea for the strict application of the laws ofbankruptcy to banks which suspend cash payments. He believedthat this would be a sufficient and effective check against over-issues.

In the ‘sixties several circumstances combined to bring thecontroversy again into the open. The currency disorders in theUnited States of America, and the publication of Coullet’s book, “LaCirculation Monétaire,” in France in 1865, invited comments in TheEconomist This journal, following in the tradition of Wilson, underthe editorship of his son-in-law, Walter Bagehot, continued to make



frequent reference to the superior qualities of a plural bankingsystem. The evidence given before the French Banking Commissionand the not very encouraging first experiences of the new NationalBanking system in America provided the occasion for furtherremarks to the same effect from time to time in 1867.

The French influence was particularly strong. Bonamy Price,Professor of Political Economy at Oxford, drew attention to thepoints of disagreement between the leading protagonists, Wolowskiand Chevalier.5 In addition, direct connections were establishedbetween the English and French economists via the Enquête.Bagehot was called to give evidence before the Commission inperson, and written memoranda were submitted by Hankey,Newmarch, Patterson and J. S. Mill. Wolowski visited London in1866 and attended the meeting of the Political Economy Club,where Bagehot was reading a paper on whether it was better “toentrust the principal custody of the bullion reserves againstbanking liabilities to a single bank or to distribute it betweenseveral banks.”6

The English reaction to the adoption by the Bank of France of thepolicy of moving the rate of discount in response to changes in itsreserve position was, in general, one of approval. It was hailed byThe Economist as the recognition at long last of a principle whichthis journal had been advocating in its pages for many years. Thetheory of discount rate, though as yet imperfectly understood as tothe details of ail its effects, and especially of its effects on the priceand income structure of the country concerned, had received fairlygeneral acceptance in England under the influence of the writingsof MacLeod7 and Goschen,8 who had at least made it clear to thebanking world that the discount rate could be used to influence thebalance of payments and gold flows.

Goschen made a direct attack on the low discount rate school inFrance,9 and insisted that the higher rate of discount which hadprevailed over the preceding few years must be interpreted as theresult, not of the artificial tampering with the natural state ofthings as Pereires claimed, but as the result of the free play ofnatural forces which had raised the demand for free capital andtherefore its price.

Nevertheless, the views of the Pereire group in France were notwithout protagonists in England. Best known among them was ajournalist named Patterson, who gained sufficient recognition to beinvited to submit a memorandum to the French Commission.10 Heextended to the case of the Bank of England the view that it wasthe monopoly of the note issue and the monopolist’s attempt tomaximise profits which caused it to raise the rate of interest.



Changes in the rate of discount were an unmixed evil to be avoidedat all costs except in so far as under a free and competitive systemof note issue they would become “natural.”11 The monopoly of theBank of England was attacked also by Guthrie.12 Although in manyrespects a crank, he called attention to one important aspect of afree-banking multiple reserve system. He submitted that under freebanking, where each bank would be obliged to hold its own goldreserves, there would be a much closer connection between noteissues and gold reserves, and that over-issues and the drains ofbullion to which they led could be checked before they becamedangerous. Should the tendency show itself, he said, “’All thebanks, being at the same time dealers in bullion and in discountsand holding only the quantily of bullion required as the basis oftheir own trade, would at once feel the withdrawal of gold fromtheir coffers and be all constrained immediately without referenceeither to their issues or deposits to reduce the amount of theirdiscounts in proportion to the cash they hold.”13 This would meanthat in a free-banking system banks could not escape from a strictadherence to the rules of the gold standard and the currencyprinciple, but the whole tenour of these remarks was in curiouscontradiction to a thesis of the same author’s, that it was amistaken policy for the Bank of England to keep a fixed price forgold instead of allowing its price to vary just like that of anyordinary commodity in response to changes in supply and demand.The monopoly of the Bank of England was, according to Guthrie,the primary cause of commercial crises. MacLeod also stated thisview but did not effectively substantiate it.14

Another feature of Continental thought at this time which had itscounterpart in England was the attack on all fiduciary issues, led byCernuschi and Modeste in France, and Tellkampf and Geyer inGermany. The English sponsor of these doctrines was EdmundPhilipps.15 He was chronologically prior to the Continentalexponents except for Tellkampf, but attracted much less attention.He believed that so long as the Bank of England issued more notesthan it had gold to redeem, it would be forced on occasions tosuddenly call in its notes and raise discount rates, and he went sofar as to suggest that if the Bank of England would not accept acharter under the condition that convertibility in his sense shouldbe maintained, any of the joint stock banks would be pleased to doso.16 This kind of argument never gained any following in England,however, and passed practically unnoticed.

Let us now revert to the more general aspects of the question ofunity as against plurality in the note issue. Bagehot’s remarksbefore the French Commission were confined to the specificquestions relating to the French case. The French system wasinferior to the English system, he said, because in England each



little town had its two or three banks and these provided facilitiesfor the collection and utilisation of savings such as did not exist inFrance. On being asked whether unity or plurality in the bankingsystem would be the best system for England, he replied that thequestion was at the moment indifferent to her, because the resultthat the multiplicity of banks serves to obtain had already beenreached: the collection of idle savings and the prevention of “theirgoing to waste” was already well accomplished. On the theoreticalquestion, he added, he was not required to speak.17

It was the opinion of J. S. Mill, as expressed in his writtenmemorandum to the Enquête, that the importance of the choicebetween unity and plurality of banks had been exaggerated. It hadbeen generally assumed that a plural banking system wouldincrease credit facilities, and this assumption had been the reasonboth for the praise of the partisans and for the opposition of theenemies of a plural system. But Mill thought that, in fact, thesystem would realise neither the benefits claimed by the one sidenor the inconveniences envisaged by the other, because after aperiod of adjustment, we should, he believed, find the notecirculation distributed among a certain number of banks who wouldcollectively conduct themselves in much the same way and providejust about the same credit facilities as the single bank under theold system. No one bank could augment its issues exceptmomentarily, because of losing its reserves to other banks, and anincrease in credit would take place only when it was provoked orfavoured by general causes acting on all banks at once, and everytime such causes came into play they exerted an exactly similarinfluence on the single bank in a unitary system. There wouldconsequently be no very great practical difference between the twosystems.18

That Bagehot, on the other hand, thought that there would be veryreal and important differences between the two systems becameclear in his writings in The Economist and in his book “LombardStreet,” which he published in 1873. In the first place, it was theadvantage of the multiple system of local issues that it produced amuch more rapid development of banking over the country. Adiffused system of note issue prepares the way for deposit businessby establishing the credit of the banker. It is much easier toestablish this by way of note issue, because the initiative is more onthe side of the banker than in pure deposit banking. Moreover, sucha system was better adjusted to loan business, because thepartners in provincial banks usually belong to the district and havelocal knowledge which puts them in a better position to estimatethe risks involved in lending to particular enterprise of individuals.Whatever had been the faults of the country note-issuing bankers,and acknowledging that we might not wish to see their return, they



had done us a great service in the beginning. It was because we inthis country had had a diffused system of note issue in the earlydays that we had outstripped other countries in all types of bankingbusiness. Admittedly, after a country has once succeeded indeveloping a paper currency and the other banking business towhich this is an introduction—by whatever means this has beenaccomplished and however slowly or rapidly—the case for amultiple system of note issue ceases to be of so much practicalimportance, and Bagehot always refers to the question as beingone of deciding whether it is advisable, in the abstract, and whenwe begin de novo to grant a monopoly. Accordingly, there was in hisview no case for the Pereire plan of setting up a second bank ofabout equal strength alongside the Bank of France, in Paris,because Paris had already become accustomed to a notecirculation, and in any case he thought the plan deserving of gravesuspicion, since it came from the same people who objected to arise in the discount rate. So far as provincial banking wasconcerned, it was plain that facilities were poorly developed ascompared with England and Scotland, and this must be attributedto the lack of country issues in France. Nevertheless, he did notfeel justified in advocating a return to a system similar to the olddepartmental banking system, because, he remarks rathercynically, “we may lay down a principle that every credit currencypermitted in France should be such as could be made legal tenderthe day after a revolution.”19 Considering the problem quite apartfrom such questions of expediency, however, he was convinced thata country starting de novo would do better to have a multiplereserve system, such as that of New York, rather than the Englishor French system20 of a privileged monopoly which was essentiallya single reserve system. It was not yet generally understood thatthe Banking Department of the Bank of England did in fact hold theonly reserve of ready cash against the banking liabilities of thecountry, and it was important to make clear the effects of this onthe position of the Bank. We had in England evolved a system inwhich not only practically the whole of the gold reserve (i.e., thereserve against notes), but also the whole of the banking reserve(i.e., the reserve against deposits) of the country was kept by asingle institution. This had grown out of the privileged position inwhich that institution, the Bank of England, had been placed byGovernment interference in banking. “The natural system—thatwhich would have sprung up if the Government had left bankingalone—is that of many banks of equal or not altogether unequalsize.”21 Instead of that, we had a central bank, and a centralbanking system had certain characteristics, liable to becomedangerous if not very carefully handled, which distinguished it fromdecentralised multiple reserve system. The two respects in whichthe centralised system showed the most marked difference were,



firstly, in the effect on the total cash reserves of the banking systemas a whole, and secondly, the reliance on a “lender of last resort.”

The commercial banks under this system, instead of keeping eachits own gold reserves, keep their reserves in Bank of England notesor in claims, in the form of deposits at the Bank, on Bank ofEngland notes. Each bank in estimating the proper distribution ofits assets between immediately realisable and less immediatelyrealisable, so as to ensure what it thinks is the necessary degree ofliquidity, regards what it holds on deposit at the Bank of England as“as good as cash,” so that according to the calculations of thecommercial banks their cash reserves should amount, in addition tothe sums of actual cash they keep in their tills, to the whole of thatsum which appears on the Bank of England’s books as bankers’deposits. But what the Bank of England has at any time available incash, that is, notes in the Banking Department, is always very muchless than this—it is only half or even a third of its depositliabilities—because the Bank relends part of the reserves of thecommercial banks. The virtual pooling of the reserves of all theseparate banks means that in normal times the Bank of Englandcan count on withdrawals by one bank being counterbalanced byadditional depositing by others. The difficulty arises in times ofpressure all round, when all banks are likely to be requiring cash atthe same time, and it is then that the disadvantages of the singlereserve system become apparent. The actual reserve held by theBank is smaller than the sum of the amounts calculated by all theseparate banks to ensure safety and which would really exist inreserve under a decentralised system. The spare cash of the moneymarket is thus reduced to a smaller amount than under thealternative multiple reserve system. MacCulloch had supposed thatbanking reserves would be larger under a unitary than under aplural system; Bagehot showed that they were smaller.

The second weakness of a central banking system is its tendency tocreate points in the system at which distress support is given. Theexistence of such refuges becomes part of the data on which thebanks base their policy. It destroys some responsibilities andcreates others. It is bound to happen that a central banking systembeing created by State aid is more likely than a natural system torequire State help, and what it knows it can depend on, it will nothesitate to utilise. This circumstance in turn leads the public todemand extra services from the central bank in times of extremityand expects that it should help the smaller establishments, and “itis,” says Bagehot, “a serious difficulty that the same bank whichkeeps the ultimate reserve should also have the duty of lending inthe last resort. The two functions are, in practice, inconsistent—oneprescribes keeping money and the other prescribes parting withmoney.”22



It is this part of the central bank’s activities—acting as “lender oflast resort”—that has been singled out by Hawtrey23 asconstituting the primary function of a central bank. In whatBagehot called “the natural system,” no bank would have anyspecial claim on any other.

In spite of the, in his opinion, manifested disadvantages of a centralbanking system, Bagehot saw no chance of giving it up and goingover to a many reserve system: such an idea he admitted waschildish, because it would take decades to build up another systemof credit to replace the trust that had now come to be placed in theBank of England as the pivot of the whole structure. Instead,therefore, of advocating the adoption of the alternative system, hetried only to elucidate canons of policy which would facilitate theless imperfect working of the one we now had.

It had been Bagehot’s aim to make the Bank Directors realise thedouble strain placed on the Bank’s cash resources in times of stressby the dual nature of its position, on the one side as holder of thebanker’s reserves, and on the other as lender of last resort. Firstly,it must be prepared to provide cash to the banks in respect of whatwas in all respects their own (viz., Bank of England deposits held asreserve), and secondly, it must provide cash by way of loan to helpsuch institutions as find their own cash resources insufficient.24This led him up to his final conclusion that the Bank must adopt amore cautious policy and that a banking reserve of one-third innormal times was too low.

Bagehot’s influence on the shaping of central bank policy musthave been more considerable than that of any other single writereither here or on the Continent. It was mainly as a result of hiscontinued emphasis that it came to be commonly admitted that thecorrect policy for the central bank in the crisis was to lend freely ata high rate of interest. He did a great deal to secure therecognition of the nature of the special responsibilities of a centralbank. His accepted thesis was a rebuttal of what was considered atthe time to be one of the cardinal principles of the 1844 Act,namely, that the Bank of England should be released from anyobligation to pay attention to the public interest in framing itspolicy and should be at liberty to act for the benefit of itsshareholders, the principles of management by the BankingDepartment being the same as those regulating any other largedeposit bank. J. S. Mill had supposed this principle to have beenalready rejected by 1857.25 But it was not easy to obtain generalagreement among the Bank Directors. Immediately after the crisisof 1866 the Governor of the Bank made a public announcementbefore the proprietors that the Bank had conceived a duty to havebeen imposed on it of supporting the banking community and had



accordingly lent unflinchingly during the crisis at a cost of a greatreduction in its reserves.26 Bagehot took this as anacknowledgment by the Bank that it kept not merely the currencyreserve (gold) of the Country, but also the banking reserve, andthat it should use the funds of which it was thus given command tohelp the banking community in time of a crisis.27 One of the BankDirectors and a former Governor, Thomson Hankey, deniedvehemently that any such responsibility had been admlitted.28 Heregarded it as a most pernicious doctrine to expect the Bank to dowhat was quite inconsistent with the ordinary workings of a depositbank, namely, to make advances when the public demanded themto an almost unlimited extent, and maintained that the bankingcommunity must be taught not to rely on the Bank coming to theiraid when they had rendered their own assets unavailable. In thesecircumstances a banking reserve of one-third against deposits wasample. Hankey’s views were defended also by G. W. Norman.29

Bagehot replied that whether the Bank Directors approved inprinciple or not, the Bank had, in fact, established a guidingprecedent by lending freely in previous panics (as in both 1857 and1866), and such action had become the legitimate expectation ofthe money market. If the Bank Directorate wanted to repudiate thisobligation, it should make an official and unequivocalannouncement to that effect.30

Bagehot’s “Lombard Street” really concluded controversialdiscussion on the relative merits of free banking and centralbanking. Its theme was that we find ourselves in possession of ananomalous banking system. It is not the most perfect if we wereable to choose from the beginning, but now that we have it we mustmake the best of it by clearly recognising its weaknesses, acceptingthe responsibilities it creates, and keeping adequate funds on handto meet them.

We find Goschen re-echoing Bagehot’s warnings respecting theinadequateness of reserves about twenty years later in connectionwith the Baring crisis of 1890.31

We show below the chief disputants in the free-banking controversycross-grouped with their standpoint towards the banking andcurrency controversy:



Free CentralParnell Tooke

Wilson BonamyPrice

Macleod Cairnes32Courcelle-Seneuil CouilletCoquelinChevalierCoqGarnierMannequinBrasseurHornWagner

Banking School

LaskerMacCullochG. W.NormanLoydLongfieldR. H. Mills

Cernuschi Lavergned’EichtalWolowski

Hubner TellkampfMichaelis Geyer

Knies

Currency School

Mises Neisser32 See his pamphlet (1854), “An Examination into thePrinciples of Currency involved in the Bank CharterAct of 1844,” pp. 62 ff.




CHAPTER XI

Discussions In America Prior To TheFoundation Of The Federal Reserve SystemAfter 1875 the central banking systems of those countries whichalready had them were accepted without further discussion, andthe practical choice of the one system in preference to thealternative was never again questioned. Moreover, the declaredsuperiority of central banking became nothing less than a dogmawithout any very clear understanding of the exact nature of theadvantages, but there remained one among the chief commercialcountries of the world which still lacked a central bankingorganisation: this was the United States of America. It is thepurpose of this chapter to examine some of the motives which ledto the final adoption of such an organisation by that country in1913.

As we have previously described, the banking structure of theUnited States consisted of a multitude of small independent banks,each with its business confined to a narrow area. There were in1913 over 20,000 banks, of which about 7,000 were National Banksissuing notes and the rest non-note-issuing banks operating, notunder the National Bank Law, but under the banking law of theStates in which they lay.

This was frequently cited as an example of the practical applicationof the principles of free banking. But while it was true that anyperson or group of persons complying with certain requirementscould open a bank of issue, and that the business was open to all onthe same terms, there were at least two important points ofdivergence between the American “free banking” so called and freebanking in the more general sense in which the term was used bythe writers on the continent of Europe. Firstly, the banks wereexcluded from practically all possibilities of developing branchorganisation, and most banks outside the big cities approachedmore or less to local monopolies. Secondly, the National BankingLaw, under which the “free” banks operated, specified a peculiarsystem of note issue. It is at least a supportable view that theAmerican bank organisation lacked the advantages of both centralbanking and of free banking proper.

Practically all tendencies to the growth of branch banking whichhad manifested themselves as part of the natural evolution ofbanking development elsewhere had been expressly excluded in



the United States. In the days before the National Banking Law,banks had come exclusively under the jurisdiction of the individualStates, and banking firms authorised to set up in one State had nopossibility of extending their operations by branch office orotherwise beyond the boundaries of this State into the territory ofanother. So far as the allowance of branch banking within theconfines of the individual State was concerned, the practice varied.Some States, mostly in the south, had permitted it; others hadpassed legislation forbidding it. The National Bank Act did nothingto alter this situation. It expressly stated that a bank formed underits provisions should not carry on business elsewhere than at theoffices in places specified in its certificate of association. All thatthe law allowed was that State banks which had previously hadbranches should have the right to retain them if they came into theNational Banking System.

The method of issuing notes against bond deposit instead of againstcommercial assets had shown weaknesses at a very early stage, aswe have already intimated in a previous chapter. Its advantagesbecame increasingly doubtful as time went on.

The obligation to tie up capital in a particular type of asset as acondition for the issue of notes made the volume of the note issuedependent in the long run on the profitability of these assets, andbesides affecting the distribution of a bank’s assets had reactionsalso on the form of its liabilities.

When note issue does not entail bond deposit, the bank has anunhindered choice in determining how much of the sight liabilitiesit can safely create against a given cash reserve shall be in theform of notes and how much in the form of deposit credits. Sinceboth are payable on demand in legal tender, it would be a choiceruled by the public’s preference for notes as against deposits whichcan be checked against, and it would be a matter of someindifference to the bank if it were suddenly called on by the publicto vary the proportion between the two.

But if a bank is forced as a condition of note issue to invest in Statebonds, it will, if these are unprofitable, be encouraged to get out itsloans as far as possible by way of deposit credits rather than by theissue of notes.1

We must now examine the actual facts of the case as theypresented themselves in America. State bonds, being as they werein great demand as a basis for the note issue and at the same timea decreasing rather than an increasing amount on the market,generally stood at a premium. This factor, together with theprovision by which a bank could only issue notes to the extent of 90



percent of the face value of the bonds it purchased, greatly reducedthe profitability of locking up funds in these bonds for the purposeof obtaining notes, and where a bank could get out its loansotherwise than by notes, it naturally preferred to do so. This causedvariations from district to district as well as from year to year, andtended to increase deposit credits disproportionately to theincrease in the note issue. In parts of the country where peopleinsisted on having notes, banks charged a higher rate of interestthan in those parts of the country where borrowers could beinduced to take deposit credits and where check paymentspredominated over demands for currency withdrawals in the formof notes.

Looking at the long period movements in the circulation we findthat between the inception of the National Banking System and1900 they exhibit a trend which cannot but be considered asexceptional if compared with that of the note issues in othercountries not working on a bond deposit basis. At the beginning ofthe ‘eighties the Federal Government began to reduce itsindebtedness by paying off its bonds; so that a scarcity of note-backing medium arose, and what there was stood at a highpremium and gave a correspondingly small return. Thereconsequently ensued a rapid reduction in the National Bankcirculation outstanding, and between 1881 and 1890 there was adecrease of some 60 percent. During the whole of the period, whennotes were diminishing or practically constant in volume, there wason the other hand a rapid increase of bank reserves of cash (chieflyof specie; legal tender notes remained a fairly constant element),and also a steady increase in deposits. This was quite contrary towhat would be expected under an ordinary asset currency, whereinflows of specie, whether from abroad or from internal hoards, areaccompanied by increases in note issues.

A great deal of comment was also raised by the inelasticityexhibited by the note issue in the short run. The fluctuations shownunder an ordinary system in the proportion between note anddeposit liabilities, especially in response to seasonal changes indemand, found no parallel in America in spite of its largeagricultural interest and heavy crop-moving demands for cash. Thefailure of the note circulation to respond to these demandsintensified the autumnal strain on the money market and thebanking system.

The explanation of the inflexibility of the note circulation lay asmuch in its lack of contractibility as in its lack of expansibility. Itwas expensive and slow to negotiate the purchase of new bonds inorder to obtain additional notes from the Comptroller when theneed arose, and the incentive to do so was further diminished by



the fact that the notes could only be retired after the need hadpassed, by going through the same formalities and expense.Moreover, there was a legal limit on the number of notes that mightbe retired in any one month.2 Notes once taken out by any bankwere usually used by that bank to the full extent. It did not keepbut a very small proportion on hand for periods of extra heavydemand for hand-to-hand currency, and so, in times when suchdemands arose, the banks could only meet them by drawing ontheir cash reserves and paying out legal tender, and they werepressed to a sharp restriction of credits all round in order to meettheir obligations.

The lack of any reserve of notes led to frequent and violentfluctuations in interest rates. There was every year a steep rise inthe autumn.

The popular illusion that the securing of notes by bond depositwould guarantee that they would always be paid in full had beendispelled. Later observers came, moreover, to realise that thesystem was responsible for suppressing some of the natural checksto over-expansions. It made the return of notes to the issuing bankfor redemption in the ordinary course of business very infrequent.The uniformity of the form of the notes of different banks, as wellas the semblance of indubitable security with which they wereendowed by the law, caused the public to regard the notes of onebank as being as good as those of any other. More important stillwas the failure of the banks reciprocally to return each other’snotes. Instead of sending in the notes of its rivals for clearance, abank usually paid them out again over its own counter. This wasdue, in the first place, to the trouble and expense involved insending notes back to the redeeming agencies which, in theabsence of branch banking, were few and far between,3 and in thesecond place, to the absence of any immediate incentive, in view ofthe costliness of the issue, for a bank to replace foreign notes by itsown. These circumstances removed one of the tests which warns abank when it is over-expanding by drawing on its reserves at anearly stage.

A series of acute financial crises occurred in fairly quicksuccession—1873, 1884, 1890, 1893, 1907. Crises occurred onmost of these occasions in London as well, but they were nothinglike as stringent. Money rates in New York rose to fantastic heightsas compared with London, and there was one other even moremarked dissimilarity. In America there took place in three out ofthe five cases (1873, 1893 and 1907) widespread suspensions ofcash payments, either partial or complete, with currency at apremium over claims on banking accounts. These tendencies



culminated in the crisis of 1907, when suspensions lasted in somemeasure for a period of over two months.

There had been for some time a growing dissatisfaction with thefundamentals of the American system. The most obviousdistinguishing feature, and the one to which attention was firstdirected, was of course the method of note issue, and some of thecritics believed that the defect was connected solely with thissystem of issue against bond deposit, and that it would not bepresent under an ordinary asset currency. Its failings weresummarised under the term “inelasticity.” This is a term which hasfrequently had a dangerous connotation, being more often than nota cloak for the advocacy of inflation, but, as we have alreadyexplained in a previous section, there was some justification in theAmerican case for the accusation that the note issue lackednecessary elasticity. It failed to provide for fluctuating demands forcash, firstly with seasonal, and secondly with crisis needs. It wasthe deficiency in supplying the latter that was given mostprominence. The problem was how to provide an “emergencycurrency.”

It was observed after 18794 that it was chiefly pressure exerted onthe banks by depositors to withdraw hand-to-hand cash and not bynote-holders to withdraw legal tender money that precipitatedsuspensions. It was contended, not unreasonably by the banks thattheir suspensions were the direct result of their being unable toissue extra notes. If they had been able to do this, they could havesatisfied the demands of their depositors for cash by giving themnotes, and in these circumstances the demand of customers forcash, both in the narrower sense and in the wider sense (that is, inthe sense of paying out legal tender for either notes or deposits ifand when demanded), could have been maintained. The demand ofthe public was only to change the form of the medium—fromdeposits to notes: they wanted simply hand-to-hand currency andwould have been as well satisfied with bank-notes as with legaltender. Reserves of legal tender could then have been keptpractically intact—the additional note-holders would not havedrawn on them; but as it was in the face of the inability to issuenotes, the demand for cash by the depositors could only be satisfiedif at all out of the reserves of legal tender, and these would soonhave been exhausted. The suspension of cash payments was,according to this view, due to the lack of variability in the form ofthe currency (current accounts to notes).5

Some attempts were made to remedy the situation along the linesof this argument. It had been suggested by the promoters of whatwas known as the Baltimore Plan in 1894 that the bond depositsystem should be abandoned altogether in favour of an ordinary



asset currency accompanied by a safety fund guarantee. Thisproposal was, however, never taken up very enthusiastically. In1900 measures were introduced to make the note issue moreprofitable. An Act was passed to allow banks to take out notesequal in value to the full face value of the bonds they depositedinstead of only to 90 percent of that value, and the tax on the noteissue was reduced from 1 percent to 1/2 percent. After 1900, too,the Secretary of the Treasury interpreted the law in a very liberalway and accepted municipal and other stocks for note backingwhere previously only strictly Government securities had beeneligible. The object of this step was to increase the circulation inthe autumn to meet the demands of crop moving. It was intendedto be purely a temporary seasonal increase, but failed to serve thispurpose because the circulation did not contract again after theseasonal demand for cash had fallen off, and so there was in thenext year just the same lack of provision for the autumnal cashdrain as before. In general, these measures served only to make apermanent increase in the circulation without increasing its shortperiod elasticity. It still left no slack ready to be taken up in anemergency. The result was merely a progressive increase in thecirculation between 1900 and 1907 of over 90 percent, whichprovided currency for the inflationary boom of those years. As wasevidenced by the events of 1907, the bond deposit system hadproved incapable of modification in the direction of providingincreased bank currency for emergencies.

Other attempts at interpreting the cause of the difficulties laid lessstress on the question of note issues and sought the primaryexplanation more in other features of the American structure. Oneof these was the system of legal reserve ratios.6 So far as thepossibilities of credit expansion were concerned, the requirementsof minimum reserve ratios probably did not cause the banks toexpand less than they otherwise would; the legal minimum was agood deal below what the banks of their own accord thought fit tokeep in normal times. But immediately the sort of event occurredfor the very purpose of which such reserves should be kept, namely,an extra heavy demand for cash, the banks could only use theirreserves to a very small extent before they approached the legalminimum. If they were not to be allowed to fall below the legalminimum, there was very little slack for taking up in times ofpressure. So if deposits were being withdrawn rather more rapidlythan usual, the situation could only be met by immediately callingin loans, thus cancelling some deposits and thereby diminishing thetotal amount of necessary reserve money. Such a procedure forcesas much liquidation as if the banks were without cash reserves, andif the process is at all general, affecting a large number of banks,the liquidity of the individual bank is lost in the liquidity of thewhole system.



The banks were faced with these alternatives: either they couldsuspend cash payments immediately, or they could use their cashreserves as far as possible to meet current demands in the hope ofstemming the demand for cash and rendering such a suspensionunnecessary. Under the American law a bank falling below its legalreserve requirements was obliged to discontinue lendingoperations until the deficit had been made good. This enforced onthe banks endeavouring to maintain cash payments in the crisis apolicy of immediate loan contraction. Given the choice, then,between falling below legal reserve requirements and suspendingpayments immediately, it was a much easier way out for the banksto choose the latter course. Such a procedure stopped the claims ofdepositors and made it possible for the banks to give their debtorcustomers time to repay their loans and even to give new loans sofar as people were still willing to take payment in uncashablechecks, or (in the case where payments were still made on a certainpercentage of deposits) in partly cashable checks. The banks mightfind that this policy promised more likelihood of their customersbeing able to pay back their loans in the end than if theyimmediately caused them to go into liquidation.

At all events, the banks seemed to have suspended paymentsimmediately as they approached the legal reserve limit, whichmeans while they were still in a very strong reserve position. Thefigures of the reserve positions, given in the Annual Reports of theComptroller of the Currency, are averages for all the banks in eachState or Reserve City, and so cover up the individual movements,but it seems fairly certain that the banks did not in many casesallow their reserves ratios to go below the legal limit to anysignificant extent. The action of the banks in suspending paymentswas technically, of course, an act of insolvency, but this was givenofficial sanction in a number of ways and a long tradition ofwholesale suspensions both before and after the inception of theNational Banking System had accustomed the public to theirlegality. The Comptroller allowed the banks to restrict payments fora period of several months on end and then permitted them toresume business as long as he considered their assets were“sound.” This happened in some cases even after a bank had beenput into the hands of a receiver in bankruptcy.7 The circumstancesin which the banks resorted to suspensions lent a good deal ofsupport to the view that it was primarily an elastic reserve policyrather than an elastic currency that was in urgent need.8

A third line of argument laid emphasis on the necessity for somerearrangement in the existing system of holding and utilisingreserve funds. At a very early stage the practice had developedamong the country banks of depositing balances, which theycounted as equivalent to cash, with banks in the large cities. They



kept on an average about half of their total reserves on redeposit inthis way and about half in their own vaults.9 The banks in“redemption” cities or “reserve” and ”central reserve” cities, asthey were later designated, were officially recognised as being in aspecial category as bankers’ banks by the National Banking Law.The conspicuous position held by the banks of New York city in thisrespect—in 1912 six or seven of them held between them aboutthree-quarters of all the bankers’ balances—seemed to point to theexistence of spontaneous tendencies to the pyramiding andcentralisation of reserves and the natural development of a quasi-central banking agency, even if one is not superimposed.

The position as it stood was regarded as exceedingly unsatisfactory.It had been a frequent complaint in financial circles ever since1857 that the practice of re-deposit by the country banks with thecity banks, and more particularly with the banks in New York City,encouraged by a number of these banks who paid interest ondemand deposits, gave an unhealthy stimulus to speculation on theStock Exchange by flooding the call loan market with cheapaccommodation. It was, what is more important, nearly always thedemands for withdrawals of these bankers’ balances by theircountry owners which precipitated crises in the financial system ofthe country.

The development of the debtor position of one group of banks, thetown banks, to the other group, the country banks, and the extremeinstability of this element in the financial structure, is one whichwould probably have been unimportant if there had been branchbanking. The absence of branch organisation may have tendedsomewhat to raise the level of the amount of call loan money, and itmost certainly made it more unstable than it would have been withbranch organisation.

The difficulties of a unit bank as compared with a branch system indiversifying risks both in its assets as well as in its depositliabilities was partly compensatable by the possibility open to thecountry banks of putting funds on deposit with a town bank and soindirectly taking advantage of the opportunities for investmentoffered by the money market. The country banks regarded thesedeposits as their second line of defence—as part of their liquidfunds which they would be able to withdraw immediately thedemands for cash from their customers increased, as happenedregularly in the crop-moving season, and they were given officialrecognition as such by the provision of the National Bank Act,which allowed such deposits to be counted by the country banks asa certain portion of their legal reserves. It is not denied that undera branch system funds from the country would still find their way tothe call loan market via the head office or town branches of the



parent bank, but the much more restricted range of alternativeinvestments available to one bank in a unit system probably causedrather more to seek this particular outlet.

The unit system with the practice of re-deposit showed greatsusceptibility to the spread of panic both in the case where theoriginating disturbance started in the affairs of a country bank, andin the case where it arose at the city bank end. Firstly, a countrybank in a unit system is less able to obtain funds from outside whenit is under pressure. It may, it is true, be able to borrow fromanother bank, but this is more difficult and takes longer tonegotiate than a transfer of funds from the cash reserves of otherbranches of the same bank, and it is the ability to obtain funds intime that is important in order to stop the loss of confidence amongthe public which leads to a panic run liable to spread to otherbanks as well. A single weak spot in the system is less likely toaffect the whole system under branch organisation than under unitorganisation.

Secondly, the call loan position in New York was renderedexceedingly vulnerable in the event of extra heavy demands forwithdrawals, and especially in the circumstances associated withthe break of a boom when call loans proved to be among the mostilliquid of assets. Experience taught the country banks that theircorrespondents in New York found it difficult to cash their depositsin such a situation. Consequently, immediately the slightestindication of defect occurred, there was a scramble by the countrybanks to withdraw their balances en bloc from New York. The fearthat they would in a few days’ time find their balances frozen ledthem to withdraw them immediately, whether they were actually inneed of cash themselves or not. Those banks who got theirbalances out in time were often found on such occasions to have farlarger reserves of cash in vaults than at periods of less acutedemand from the public. The New York banks were driven tosuspend payment, and those country banks who had not withdrawntheir funds in time had to suspend also.

The difference in a branch system would be, not that there wouldnot still occur a flow of funds from the interior of New York, butthat the greater part of these funds would be disposed of by thetown branches or head offices of the banks remitting them, andeach bank would retain direct control over its own reserves.10 Andin a period of pressure, branches would not attempt to withdraw allthe spare funds from their head office, regardless of whether theyneeded them or not. There would be a concentration of funds onpoints where they were needed most to satisfy the demands ofcustomers and stop a run.



It was realised in some quarters that many of the difficulties couldhave been remedied by the institution of branch banking alongCanadian lines, but this was regarded as a political impossibility,and so attention was turned to the more practical expedient offinding some systematic means of the more economical utilisationof reserves in a crisis within the general framework of the existingsystem.

It seemed increasingly apparent that it was impossible to rely onthe independent and unaided efforts of the banks to secure thisend. Some attempts of a somewhat unsystematic nature hadalready been made by them. One of these was the use of theclearing-house loan certificate.11 This was a practice which hadbeen started by the banks of New York and the banks of Boston in1860. A majority of the banks belonging to the Clearing HouseAssociation entered into an agreement under which, when a bankhad an adverse clearing balance, it should, instead of paying cashto the creditor bank, deposit collateral with the Clearing HouseAssociation, against which the latter should issue clearing-houseloan certificates to be received in payment by the creditor bank.The certificates bore interest at a fairly high rate, varying from 5 to10 percent, which went to the creditor bank holding them in lieu ofbalances owed. The essence of the scheme was that the banks in astrong position (with favourable clearing balances) should makeloans to those in a weaker position (with unfavourable clearing-house balances). It was intended to prevent each bank trying tostrengthen its position at the expense of the others, becausewithout such an arrangement, no bank could extend its lendingoperations and all were induced to contract because of the fear oflosing reserves to other banks at a time when the demand of thepublic for cash was increasing. On the first occasion that theclearing-house loan certificate device was used by the New Yorkbanks it was accompanied by an agreement for treating the speciereserves of all banks as a common fund so that the banks having tobear the greatest strain not from other banks, but from the claimsof the public, should be able to draw on the reserves of banks lesssubject to such strain. This pooling of reserves, or “reserveequalisation” as it was called, meant that it was quite impossiblefor a bank to affect its individual reserve position by contracting itsloans.

In the 1860 crisis the banks in both Boston and New Yorksucceeded in maintaining cash payments with the aid of the loancertificate. In the 1873 crisis the device was used again, this timeby the clearing-house associations in no less than seven of theprincipal cities. It did not succeed in averting entirely a suspensionof cash payments, but the suspension lasted the comparativelyshort period of less than three weeks.



In subsequent crises the clearing-house loan certificates were usedby the associations in nearly all the leading cities, but without theequalisation of reserves. The banks could not reach agreement topool their reserves in these later crises. Those of 1884 and 1890were, however, slight, and the banks did not suspend, but in 1893and 1907 the use of clearing-house loan certificates, without theequalisation of reserves, itself led almost immediately tosuspension.

The issue of certificates without the equalisation of reserves provedfatal to individual banks. A bank which received a large number ofchecks drawn on other banks from customers who wanted towithdraw cash, experienced heavy drains on their reserves. At thesame time they might have favourable clearing-house balances withother banks (those on which the checks were drawn) but be unableto obtain any cash from these banks on account of theclearinghouse arrangement, while these other banks might beexceptionally strong in cash reserves because customers did nothappen to be drawing directly on them for cash. The banks whichwere subjected to the heavy demand for cash by the public, or thecountry banks, as the case might be, tried to sidetrack this effect ofthe clearing-house agreement by encouraging their customers totake checks for cash direct to the banks on which they were drawninstead of handing them into their own banks for settlement in theclearings. This was, however, impossible to do beyond a certainmeasure; the banks adversely affected by the issue of the loancertificates had to suspend payment; this started a run on theothers and they suspended also.

Both the successes and the failures of the clearing-house loancertificate device gave force to the conclusion, firstly, that thereshould be somewhere an adequate reserve of lending power for usein the crisis, and, secondly, that this should be available for thecollective benefit of all banks. Further, the idea was gaining groundthat it could only be provided by an organisation in some manneraloof from the operations of ordinary commercial banks. It must bea bank that was in normal times not fully “lent up.”

Some such sort of relief during a crisis had been provided by theTreasury. The principle had been established in 1846 that theTreasury should be independent of the banks, that is, that it shouldkeep its own surplus funds instead of depositing them with thebanks. It was objected that this had an inconvenient effect on themoney market if collections exceeded disbursements for any lengthof time, because in that case it caused sudden withdrawals andreturns of funds from and to the market; and from the time of theCivil War onwards the Independent Treasury System was notstrictly preserved. The Treasury began depositing funds in selected



National Banks and adopted the practice of giving relief in times ofcrisis. The methods of using its funds in a way to make the moneymarket more liquid were various.12 As early as 1857, even beforethe National Banking System had come into being, it had helpedthe market by purchasing bonds. In 1873 it again bought bonds andalso sold $5,000,000 of gold, the proceeds of which it put ondeposit in certain banks. In 1884 it prepaid some of the interest onthe public debt. In 1890 it again prepaid interest and boughtbonds. In 1893 the Treasury was unable to give any aid at all; itactually had a deficit and needed to borrow itself from the banks.In 1907 it transferred some funds to the banks, but the amount ithad on hand was small, since it had already deposited most of itssurplus with them before the crisis.

The Treasury had thus been undertaking some of the functions of acentral bank by carrying out what was equivalent to open marketoperations (purchases of securities) and by lending directly to thebanks. The rather fortuitous nature of this kind of relief led bankreformers to demand a more “scientific” mode of relief in crises. Itwas only a lucky chance if the Treasury happened to have surplusesat the time when the crisis came. There was, on the other hand, aconsiderable body of opinion which denounced the Treasury reliefon the grounds that it gave an impetus to expansion. Banksexpected to receive assistance if they got into difficulties, andtherefore expanded on the basis of these anticipations.

It became also part of the positive programme for banking reformthat it should provide for an institution which could act as theGovernment’s fiscal agent.13 The Treasury experiences during thecourse of the previous century, both of the system of keeping itsown funds and of the system of depositing them with various Stateor National Banks at the risk of not being able to obtain them in theevent of the failure of these banks, had directed attention towardsthe possibility of finding some depositary which was free from theobjections of both these systems. In other countries the necessaryservices were performed by the Central Bank.

One other feature of the American system which the reformershoped to remedy was the high cost of check collection. Themajority of the banks in America were in the habit of making acharge known as the “exchange” charge for paying their ownchecks. This charge purported to cover the cost of providing fundsto pay the check in a distant place because the bank had either toshift currency or to maintain a balance in a distant centre. Whatthe banks were actually able to charge was probably much abovethe real expense involved, but there is little doubt that there wasroom in the old system for a considerable reduction in the real cost



of check collection by reducing the necessary amount oftransmission of funds.14

It was the crisis of 1907 which gave the final impetus to thegrowing agitation for banking reform, but there was still adifference of opinion as to whether the chief fault lay with thesystem of note issue or with the lack of branch organisation or withthe legal reserve regulations. On the whole, there was a strongmajority in favour of the introduction of some kind of co-operativeorganisation of existing banks for the purpose of providing reservefunds for panic financiering. Authoritative support was given to thesuggestion that the necessary changes could best be made throughthe establishment of a central bank of issue and reserve.15 Buteven after the 1907 crisis there was still a good deal of oppositionto the introduction of real central banking, and the idea persistedthat a purely emergency organisation for “relief” would meet thecase. This was the attitude behind the Aldrich-Vreeland Act of1908, which provided for the issue of emergency currency againstsecurities other than United States Bonds and adopted commercialbills as a basis for note issue for the first time. The Act authorisedbanks to form voluntary associations under the arrangement that abank belonging to such an association could deposit with it anysecurities (including commercial bills) against which it mightreceive additional notes. All the banks belonging to the associationwere then jointly and severally liable for the redemption of theadditional circulation. National Banks were also given the option ofapplying to the Comptroller of the Currency for additional notessecured by assets other than United States Bonds.

The same Act set up the National Monetary Commission to reporton banking reform. The Commission sat four years and carried outinvestigations, not only into the details of the American system, butalso into the experiences and practices of European countries withcentral banks. The fact that these countries had escaped generalsuspensions of cash payments was attributed to the strength of thecentral institutions, the concentration and mobilisation of reservesand the prompt use of these reserves in a crisis. Stress was,moreover, placed on the part played by these central banks of issuein regulating the money market via the discount system.16 Theinfluence of the publications of the Commission was to turn thefavour of the reformers towards a permanent central organisationwhich should issue a currency based on gold and commercialpaper, act as a lender of last resort and control the credit situationthrough the bank rate and open market dealings.

The final outcome of the recommendations was the creation of theFederal Reserve System. Its organisation differed considerablyfrom the European central bank: it consisted of twelve regional



Federal Reserve Banks in the ownership of which those banks whobecame members of the system—and membership was compulsoryon all National Banks—took a share by contributing to their capital.On these, under the guidance of the Federal Reserve Board, theredevolved the tasks of issuing notes, keeping the reserves of themember banks and acting as lending agency to them byrediscounting.

A retrospective consideration of the background and circumstancesof the foundation of the Federal Reserve System would seem tosuggest that many, perhaps most, of the defects of Americanbanking could, in principle, have been more naturally remediedotherwise than by the establishment of a central bank; that it wasnot the absence of a central bank per se that was at the root of theevil, and that, although this was admittedly a partial remedy forthings for which other remedies were politically or technicallyimpossible of realisation, there remained certain fundamentaldefects which could not be entirely, or in any great measure,overcome by the Federal Reserve System.




CHAPTER XII

The Arguments In Favour Of Central BankingReconsideredIt has been the purpose of the preceding chapters to elucidate thereasons, historical as well as logical, for the growth of the form ofbank organisation which we now call central banking. Its origin isto be found in the establishment of monopolies, either partial orcomplete, in the note issue. Monopolies in this sphere outlasted theabolition of protectionism in other branches of economic activity.Those which had been in existence prior to the growth of free tradedoctrine were retained and reinforced: new creations occurredwhere they had not previously existed.

Looking at the circumstances in which most of them wereestablished, we find that the early ones were founded for politicalreasons connected with the exigencies of State finance, and noeconomic reason for allowing or disallowing free entry into thenote-issuing trade was, or could have been given at that time, butonce established, the monopolies persisted right up to and beyondthe time when their economic justification did at last come to bequestioned. The verdict of the discussions round this problemvindicated the choice in favour of unity or monopoly in the noteissue as opposed to competition, and thereafter the superiority ofcentral banking over the alternative system became a dogma whichnever again came up for discussion and was accepted withoutquestion or comment in all the later foundations of central banks.In this chapter we shall recall and examine the main points in thedefence of central banking against its logical alternative in anattempt to weigh up the evidence and to judge whether or not it isconclusive.

It may be useful first to recapitulate the broad differences in thecharacteristics of the two alternative systems. The primarydefinition of central banking is a banking system in which a singlebank has either a complete or a residuary monopoly in the noteissue. A residuary monopoly denotes a case where there are anumber of note issuers, but all of these except one are workingunder narrow limitations, and this one authority is responsible forthe bulk of the circulation, and is the sole bank possessing thatmeasure of elasticity in its note issue which gives it the power toexercise control over the total amount of currency and creditavailable.



It was out of monopolies in the note issue that were derived thesecondary functions and characteristics of our modern centralbanks. The guardianship of the bulk of the gold reserves of thebanking system is obviously an accompaniment of the monopoly inthe note issue: the holding of a large proportion of the bankers’cash reserves is also bound up with the same factor—it is a matterof convenience for the banks to keep their surplus balances at thecentral bank but it is safe for them to entrust a major part of theircash reserves to a single outside establishment only if they can beabsolutely certain that this authority will be able in allcircumstances to pay Out such reserves in a medium which will bealways acceptable to the public. This can only be guaranteed if thenotes of this authority can be given forced currency in time ofneed. Last, but not least, control over the note issue gives thecentral bank power to exercise control over the general creditsituation. These considerations justify us in using the term “centralbanking” to cover the narrower as well as the wider concept.

A central bank is not a natural product of banking development. Itis imposed from outside or comes into being as the result ofGovernment favours. This factor is responsible for marked effectson the whole currency and credit structure which brings it intosharp contrast with what would happen under a system of freebanking from which Government protection was absent.

“Free banking”1 denotes a régime where note-issuing banks areallowed to set up in the same way as any other type of businessenterprise, so long as they comply with the general company law.The requirement for their establishment is not special conditionalauthorisation from a Government authority, but the ability to raisesufficient capital, and public confidence, to gain acceptance fortheir notes and ensure the profitability of the undertaking. Undersuch a system all banks would not only be allowed the same rights,but would also be subjected to the same responsibilities as otherbusiness enterprises. If they failed to meet their obligations theywould be declared bankrupt and put into liquidation, and theirassets used to meet the claims of their creditors, in which case theshareholders would lose the whole or part of their capital, and thepenalty for failure would be paid, at least for the most part, bythose responsible for the policy of the bank. Notes issued underthis system would be “promises to pay,” and such obligations mustbe met on demand in the generally accepted medium which we willassume to be gold. No bank would have the right to call on theGovernment or on any other institution for special help in time ofneed. No bank would be able to give its notes forced currency bydeclaring them to be legal tender for all payments, and it is unlikelythat the public would accept inconvertible notes of any such bankexcept at a discount varying with the prospect of their again



becoming convertible. A general abandonment of the gold standardis inconceivable under these conditions, and with a strictinterpretation of the bankruptcy laws any bank suspendingpayments would at once be put into the hands of a receiver.

A central bank, on the other hand, being founded with the aideither direct or indirect of the Government, is able to fall back onthe Government for protection from the disagreeable consequencesof its acts. The central bank, which cannot meet its obligations, isallowed to suspend payment and to go off the gold standard, whileits notes are given forced currency. The history of central banks isfull of such legalised bankruptcies.2

In the natural development of a free-banking system there is noapparent reason why a single bank should acquire a position ofhegemony in which the bulk of the gold and cash reserves of thebanking community were concentrated in its hands. The dictum ofBagehot, that a centralised reserve system is entirely unnaturaland that the natural system would be one where each bank kept itsown reserves in its own vaults, has been challenged by reference tothe position of New York as a reserve centre prior to 1913. Wecannot doubt the tendencies to a concentration of balances on aconsiderable scale in financial centres, and under a unit bankingsystem the out-of-town banks will carry deposits with the banks insuch a centre. The extent of this holding of balances by some banksfor the account of others would be much smaller, however, werebanks allowed to have their own branches where they chose. Thebalances that a bank finds it convenient to keep in the financialcentre, would then generally be held by the bank’s own branch inthat city, where they would remain under its own control andmanagement.

In a multiple system each bank must determine the volume of itsnote issue, or of its total demand liabilities, with a close watch onits reserve position, and it is to be expected that the total volume ofcredit a bank could safely leave outstanding would be verysensitive to changes in its reserve position. The central bank can,on the other hand, allow its reserve proportion to undergo largechanges partly on account of the concentration of reserves andpartly on the expectation that it will be released from itsobligations, if it finds itself in difficulties.3

We can now turn to the analysis of the major points at issuebetween those who attacked free banking and those who defendedit. Historically the free-banking case was connected predominantlywith those theories of currency and credit which were sponsoredby the banking school, and the central banking case was likewise,but perhaps a little less closely, linked up with the theories of the



currency school. It was not true in all instances that a member ofthe free-banking school supported the one and a member of thecentral banking school the other, but because this was true in themajority of cases, the success of the currency school was claimedas a victory for the central banking school as well. Actually thesecond controversy could be judged independently of the first andshould be regarded as distinct. We shall not deal here in detail withthe contents of the rival theses in the banking versus currencycontroversy, which are fairly familiar ground. It will suffice toremark how far the link with the banking versus currencycontroversy weighted the evidence in the free banking versuscentral banking controversy.

The circumstance that the free-banking school, especially inFrance, placed so much emphasis on that part of their argumentwhich sprang from the theories of the banking school, tended, it istrue, to cast suspicion on the free-banking case. A notinconsiderable number of the free bankers denied the quantitytheory of money, and promoted ideas that were of an obtrusivelyinflationary character. It may be recalled that according to thisschool no such thing as an over-issue of bank-notes can take placeso long as they are only issued in response to the “needs of trade”and continuous convertibility is maintained. It was their contentionthat so long as notes are issued on short-term loan (or so long asthe assets of note-issuing banks are “bankmässige”) they cannot beissued in excess. The demand for loans, and therefore for notes,will be confined to limits imposed by the profitability of borrowing.Should the issue be found to be in excess of the needs of trade,notes will come back to the bank in repayment of loans falling dueand for which there will be no demand for renewal; they willconsequently be automatically withdrawn from the circulation. Itwas also a prevalent idea that since there is no restriction on thecreation of credit by way of bills of exchange in ordinarycommercial dealings, it is inconsistent to place a limit on thatparticular mode of lending which takes place via the note issue. Ifthe banks issue notes with which they discount bills of exchange,they are merely changing the form of the lending. Since the billswould have existed in any case, the banks made no net addition tothe total volume of credit.

Notes issued on short-term loan, the argument continues, becomeonly temporarily part of the circulation, and this was held toconstitute a vital distinction between bank-notes which had anautomatic reflux and “pure paper money” which, instead of beingpaid out by way of short-term loan, was permanently released inpayment for goods and services. Real paper money made apermanent addition to the amount of the circulation, and neitherwas its quantity controlled by the needs of trade. It therefore



exerted a marked and lasting influence on prices. In the case ofbank-notes, the flowback after the expiry of the term of the loanserved also a second purpose by providing safeguards for themaintenance of continuous convertibility, since at the time of suchrepayments either the note issue was decreased or the goldreserves were increased.

It has been pointed out, in criticism of this doctrine, that it failed toperceive that borrowing on bills of exchange or on any othersecurity will not be a given quantity fixed independently of bankpolicy, but will be a function of the rate of interest charged, and canbe expanded indefinitely, provided the banks offer a low enoughrate. Secondly, if the banking school argued that the principle of“bankmässige Deckung” provided against all dangerouscontingencies, such as a threat to reserves and therefore toconvertibility, simply because notes were always only temporarilyissued and could be withdrawn at short notice, they ignored thetruth that an over-issue even for so short a period as the normaléchéance of bills of exchange cannot (if it is general to a majority ofbanks in the case of a free-banking system, and withoutqualification in a unitary banking system) be suddenly rectifiedwithout causing all those effects characteristic of a creditcontraction which are to be regarded as the evil aftermath of anyover-issue. A net reduction of loans cannot take place withoutcausing disturbances both in the financial and in the industrialstructure. One bank can only make heavy reductions withoutcausing widespread liquidations and losses in the system if anotherbank will lend to fill the gap. It is a matter of shifting, and thewhole system cannot shift at the same time. The mere fact that thebanks’ loans are on short term does not mean that a creditcontraction can take place in the nick of time without causing justthose disturbances which the currency school aimed at preventing.

There remains, however, one point connected with the principle of“bankmässige Deckung” and the automatic reflux of notes whichmight have a certain validity in a free-banking system which itcould not have in a centralised system of note issue. This pointrelates to the possibility of the mutual control between banksoperating as a check on over-issue. In a multiple system of issuethe notes of any individual bank will be continually flowing intoother banks and cleared. Now the shorter the period for whichloans are made, the more frequent will be the repayment ofoutstanding loans; and the larger the proportion of total loansoutstanding that are coming forward for repayment each day, thelarger will be the proportion of the outstanding note issue cominginto the banks on any day. If we suppose that one bank starts toexpand while other banks maintain only the same issues as before,the flow of adverse claims required to be met in gold by the former



through the clearings will be affected by the shorter or longerlength of the term for which loans are made. How far thismechanism can be effective as a break on over-issues we shalldiscuss in a later section of this chapter.4

The currency school intended to make the total circulation varywith outflows and inflows of gold in the supposed manner of purelymetallic currency. They thought that this end could beaccomplished by fixing the fiduciary note issue. Their error was tohave ignored the fundamental similarity of deposit credits to theissue of notes. This error would not have been crucial in so far as itconcerned only the deposit credit creating facilities of thecommercial banks.5 In so far as these banks keep fairly constantratios between their cash reserves and their deposit liabilities, thetotal volume of credit can be made to move in response to goldmovements (its changes will be a fairly constant multiple of suchmovements), provided the reserves of these banks are made tomove in the same way as gold. But this would require the fixing,not of the fiduciary note issue of the Bank of England but of thequantity not covered by gold, of its notes in circulation plus itsdeposit liabilities. As it is, the Bank of England can vary its lendingand so alter the volume of deposits on its books to the credit of thecommercial banks, and therefore the cash reserves of those banks,independently of gold movements, merely allowing the operation toaffect its own reserve “proportion.” It can do this within limits thatare of course widened by the willingness of the Government toabrogate the Bank Act in case of emergency.

There were mistakes and omissions in the doctrines of bothschools, and as they worked out in practice there seems not to besuch a great deal of difference between the actual results securedby those who insisted that it was essential to impose some suchrule as a fixed limitation on the amount of the fiduciary note issue,and those who believed that the only necessary regulation was thatnotes should be convertible into specie.

We may conclude that logically, in so far as the disagreementbetween the two parties free banking and central banking wasbased solely on the positions they took up with regard to thebanking versus currency controversy, there is no definite groundfor presumption in favour of either one or the other. It is,furthermore, true that, given the independent arguments in thefree-banking case which we are about to examine, it was perfectlyconsistent for the currency school, in so far as their aim was to finda system in which there were checks on fluctuations in the volumeof credit, to sponsor the free-banking case. Both Michaelis andMises are in this position.



The decisive arguments, and those, therefore, on which the casecan be exclusively discussed, are the arguments introduced byeither side additional to, and independent of, the points at issuebetween the banking and currency schools. We shall, therefore,turn our attention to the major arguments of the free bankingversus central banking controversy proper. The points that havebeen raised in defence of the one system or in condemnation of theother can be dealt with under five heads.

The first of these is an argument against free banking, which runsin the following terms. It is always to be expected under a multiplebanking system that even if the general stability of the wholesystem is assured, there will be failures of individual banks fromtime to time, just as there occur bankruptcies among the firms inother industries. The notes of any bank do not stay in the hands ofthose people who are enabled to borrow from that bank andtherefore directly benefit from its note issue. They are paid awayinto the hands of third parties who have no immediate connectionwith the bank concerned. Those people who happen to be inpossession of the notes of the failed bank at the time of its failurewill suffer loss. A large proportion of such notes is likely to be inthe hands of those who are either too ignorant, or by reason oftheir subordinate position, unable, to refuse to accept the notes ofa bank which a more informed or better-placed person would rejectbecause of suspicion attaching to the affairs of that bank. In otherwords, there is placed on the community the burden ofdiscriminating between good and bad notes, and it falls especiallyhard on those sections of the community who are least able to bearit. It is, therefore, concluded that the Government should interveneand protect the note-holder by introducing some uniformity into thenote issue. In the last analysis this is an argument for spreading therisk evenly among all note-holders. Whether or not we accept it isnot dependent on economic analysis, and it is a question which wecannot decide on scientific grounds. We can but call attention tothe suggestion of the free bankers that the spreading of the riskcould only be done at the expense of increasing the losses allround.

The second point and the one to which most attention has usuallybeen devoted is the question of the relative probability of inflationsof the currency leading up to the phenomena of crises anddepressions. The central banking school supposed that under afree-banking system fluctuations in the volume of money andtherefore in economic activity in general would be much moreviolent than in a system where there was a single note issuer. In afree-banking system competition among the banks would provoke aconstant tendency to the lowering of discount rates and increasesin the volume of credit. It would be followed eventually by an



external drain of gold, but this was a check which operated toolate, because by the time the drain began to affect the banks’reserves the seeds of the depression had already been sown, andthe crisis would only be made more intense by the suddencontraction of lending forced on the banks by the urge to protecttheir reserves.

It was further argued that any tendency to expansion wouldbecome cumulative, because it was useless for some banks, whomight be more acutely conscious of the difficulties that would arisein the event of an expansion and the resulting pressure onreserves, to hold off from expanding. They could not hope forescape from the strain by pursuing a conservative policy whileothers were inflating. The reasoning on which this conclusion wasbased is the following. When the public starts to demand gold forexport, they will not select the notes of the guilty banks andpresent these for payment. They will send in any notes that comeinto their hands, and the proportions in which the notes of thedifferent banks will be returned will roughly correspond to theproportions the note issues of the individual banks bear to the totalcirculation. Hence the non-expanding banks have to bear part ofthe pressure resulting from the expansion of a rival bank. Should anon-expanding bank insist on retaining its former reserve ratio, itwill be compelled as a result of the encroachment on its reserves todecrease its lending. If this happens, the expanding bank (or groupof banks) can go on expanding and taking business away from itsrivals until the latter are finally driven out of business and theformer obtains a de facto monopoly. So whether the banks with themore conservative tendencies expanded or not, they could not helplosing reserves, and if they did not expand, they would losebusiness. Consequently, the argument runs, they will, in theinterests of self-preservation, be induced to join in the inflation.

The flaw in this argument is its failure to observe that as a result ofcontinuous expansion by one group and continuous contraction bythe other the proportion of the gold outflow falling on theexpanding group must increase pari passu, and that the reserves ofthis group will be exhausted entirely before the conservative grouphas been driven out of business.

The argument so far considered refers only to the unreliability of acheck on inflation by way of the presentation of notes to the banksfor redemption by the public. The freebanking party laid particularstress on another check which they contended workedautomatically through the reciprocal claims of the banks upon eachother’s reserves.6 Any bank will continually be receiving paymentsfrom customers either in payment of loans or in the form of cashbeing paid in on deposit. In a system where all banks are



competitors for business, one bank will not be prepared to pay outover its own counter the notes of rival banks, but will return themto their issuers through the clearing process. It is therefore to besupposed that if one bank expands out of step with the rest, theclearing balances will go against it and its rivals will draw on itsgold reserves to the extent of its adverse balance. This mechanismwould work at a much earlier stage than the external drain of goldand would cause the reserves to feel the effects of expansionalmost immediately. It is unlikely that all banks will decide inconcert to decrease their reserve ratios, and the bigger theconservative group which is not desirous of so doing, the strongerwill be the check of these on the expansion of the other group. Abank which contemplates an expansion has got to take into accountnot only the direct effect on its reserve ratio, which comes about inthe first instance when it increases its issue against the sameabsolute total reserve as before, but also the indirect effectoccasioned by the withdrawal of cash to other banks. The size ofthe addition it can afford to make to its loans on the basis of a givendrop in its reserve ratio will be correspondingly reduced, and itsaction will react partly to the benefit of the other banks who securean accretion to their reserves. While admitting that circumstancesmay occur in which the majority of the banks are willing to allowsome reduction in their reserve ratios, it is unlikely that they willever risk fluctuations of dimensions anything like as great as thosewhich are viewed with comparative equanimity by the central bank.

The free bankers therefore submitted that under their system anover-expansion was not only not any more likely, but even muchless likely than under a central banking system. In the latter systemall notes are issued by a single bank: this bank receives allpayments in, in its own notes, and can always pay its own notes outagain; it therefore neither gives nor receives claims on speciereserves so far as inter-bank claims are concerned. The only sourceof claims is the demand for gold by the public. The effect could beseen in the very much longer average period of circulation (lessfrequent redemption) of notes under a unit system as comparedwith a multiple system of note issues.

The central banking school alleges that inter-bank control via theclearing mechanism is largely an illusion, and only functions undervery special circumstances. If one bank increases its issues by agiven proportion, its business will increase in the same proportion,and therefore the larger amount of loan repayments it will havefalling due in any week will give it the same number of claims onrival banks as they have on it, so that no differences arise in theclearings and no claims on reserves.



It was consequently denied that, failing recourse to the situationwhere the notes of any one bank circulate, not over the whole area,but only over a narrowly circumscribed area, in which case notespassing out of their area of issue would be sent in by the public forcollection7 — a case which is analogous to that of internationalexchanges and which raises objections of its own—there is anyautomatic check on the expansion of note issues in a multiplebanking system.

The argument as stated and the illustrations8 given in support of ittake no account of a lag occurring between the increase in thecirculation of the expanding bank (which we will call A) and theincrease in its loan repayments. If we assume such a lag which inpractice must occur, there will be a drain in the first instance on A’sreserves, though this will only be a temporary efflux, and at a laterperiod, when A’s loan repayments increase, there will be a return ofthese reserves to A.9 It seems, therefore, that whether or not theclearing mechanism will act as a factor tending to check A’sexpansion will depend on whether or not A can stand the reductionin its reserves during this interim period.

It is always assumed that in the case of a deposit credit system, theclearing mechanism will function against a bank which expands outof step with others.10 The only differences between the two caseswould seem to be that the temporary withdrawals in the lag periodwill be more rapid in the check case than in the note case. Allchecks which are drawn on the additional deposit credit, as theborrower spends it, will be paid into the banks for clearanceimmediately, and those drawn in favour of people banking withother banks will give rise to cash claims on the expanding bank.None of the checks will remain out in circulation; all will passthrough the clearings. In the case of the note issue, on the otherhand, only a small part of the issue will come back from circulationto the banks—viz., those notes that come in via loan repayments orin the form of new deposits. Eventually the expanding bank wouldget back the reserves it previously lost in the deposit case no lessthan in the note case, but the clearing mechanism exerts acontrolling effect because the bank cannot stand a heavy reductionof reserves in the interim period; it cannot wait until their return ata later date.

The difference is a matter of degree rather than of kind. Whetheror not the check will operate in the note case will be dependent onthe importance of the drain of cash during the lag period. Thatthere must be some lag, whether we take the note case or thedeposit case, is indisputable11 unless we adopt the unrealassumption that all the additional loans are lent out only “overnight.” The existence of the lag presupposes merely that the



additional loans do not mature at the next settlement day but onlyone or more settlements later, or that the shortest period for whichthe loans may be made cannot make their repayment coincide withthe repayment of those old loans which are the next in time to berepaid. It must be supposed that the borrower makes use of theloan proceeds and therefore transfers of funds must have takenplace between the time of borrowing and the time of repayment.The borrower must first use the funds to make a purchase and laterrealise them again by making a sale. The purchases which the newborrowers make will partly provide the funds out of which previousborrowers, whose loans are falling due, make their repayments tothe banks. At a later date other borrowers will provide the fundsout of which our so-called new borrowers again become liquid andcan pay back their loans. The most rapid rate at which suchtransactions can proceed must allow at least one settlement to takeplace in which the effect of the increased circulation of theexpanding bank becomes apparent in the clearing balances, buthas as yet no effect on the volume of loans falling due forrepayment.

We can make various assumptions about the term of the old and thenew loans. If the term of loans is on the average increased with anincrease in their volume, the lag period will be longer than if this isnot the case. There seems no reason for assuming that the lengthof the lag will be any greater under the system of loan by depositcredit than under the system of lending in the form of notes. Theonly difference is that the size of the temporary drain will be largerin the deposit case than in the note case. Even allowing for the factthat some additional notes will find their way into the banks at anearly stage in the form of new deposits by customers as well as byway of current loan repayments, it remains true that this isextremely unlikely to approach anywhere near the extent of thereturn of checks. It is possible, however, that the drain of cashcaused by the reflux of notes to other banks during the lag periodmay still be sufficient to act as a deterring influence on individualbank expansions. That it can be sufficient would seem to have beenborne out in the experiences of such practical examples ofcompetitive note issues as are afforded by the history of the Scotch,Suffolk (Massachusetts) and Canadian systems.12 Banks in each ofthese systems seem to have been definitely conscious of the powerof holding other banks in check by the return of notes through theclearings.

What influence will the average period for which bank loans ingeneral are made have on the withdrawals in the lag period? It willaffect the rate of withdrawals. The shorter the average term of allloans outstanding in the banking system the greater will be thewithdrawals of cash per week after the expansion, but the shorter



will be the lag period, if we assume that the expanding bank hasthe same average term for its loans as the banking system as awhole. It may be that a sharper pressure on reserves at an earlydate will act as a more immediate incentive to the expanding bankto hold back, and if this is the case it gives some justification forthe principle of “bankmässigeDeckung” and automatic reflux ofnotes on which so much emphasis was laid by the banking and free-banking schools.13

Besides questioning the ability of a non-expanding bank to exerciseany control over the expanding banks the central banking schoolhas also cast doubt on the realism of the concept of the so-calledconservative bank and has submitted that the profit motive maylead all banks to join in an expansion.14 The term conservative wasintended to imply that the bank for some reason resists the forcescausing others to expand credit. If we suppose that there occurs arise in the demand for capital (a rise in the “natural” rate ofinterest) it is possible for all banks to get out more credit so long asthey keep the market rate of interest at or about its old level, and ifthe elasticity of demand for credit is greater than unity the grossprofits of all banks will be greater if they lend more at the old ratesthan if they lend the same at a higher rate. If they lend more, ofcourse, they do it at the expense of a reduction in their reserveratios. If all or a majority of them are unwilling to increase theirlending and lower their reserve ratios the market rate of interestwill rise towards the “natural” rate, but the fewer are the numberof banks who insist on retaining their old reserve ratios the smallerwill be the rise in the money rate and the greater the extension inthe volume of credit.

A bank which is conservative must be supposed to foresee theevents following on the boom, so that it anticipates that the profitsit could gain by joining in the boom would be subsequentlycounterbalanced by the losses of the crisis when credit customerswithdraw cash and debtor customers are unable to repay theirloans. But it has been suggested that such banks, even though theyare fully aware of all the consequences of an expansion, will nothave any incentive to hold off from it, because they will find thatthe profits of the boom more than compensate for the losses of thecrisis and depression; and the larger is the number of the bankswho want to expand, whether because they do not foresee thecrisis and depression or because they compute the gains as greaterthan the losses, the more unprofitable will it be for any individualbank to stay out, since it has small chance of escaping entirely fromthe effects of the crisis brought about by the policy of its rivals.15This argument is however still open to the question whether it islikely that the profits would exceed the losses, and thereforewhether there would be many banks willing to lower their reserve



ratios, if there were no central bank to give external aid during thecrisis and the banks were always under the threat of liquidation inthe case of a suspension of specie payments. The risk necessary totake in order to make the extra profits in the boom would includethe possibility of insolvency.

The third argument, advanced in favour of central banking, is thata central banking institution has by reason of the confidence placedin it by the public the power to mollify the difficulties of a crisis. Itwas explained that in a crisis the banks in a free-banking systemwould be under pressure from their creditors for payment in cashand would be compelled, in consideration of the safety of their ownreserve position, to contract their lending. All banks would bedoing the same and borrowers previously accommodated by themwould be forced into liquidation. Many of the banks themselvesmust fail in the process. No bank would be willing to increase itscirculation for fear of getting more notes brought back for gold andthere would be no other lending agency to ease the situation. Ifthere is a central bank, on the other hand, such a bank canincrease its circulation in the crisis without fearing an internaldemand for gold, since people are willing to accept its noteswithout question. The gaps that would otherwise be left by thecommercial banks in the credit structure when the crisis constrainsthem to draw in their loans, can therefore be filled by the centralbank acting as the lender of last resort. It can carry out thisfunction of making the market more liquid either by lending directto the banks or by lending to those who are called on by the banksfor repayment.16

When the public withdraws large quantities of cash from the banksthe lender of last resort lends to fill the deficiencies. This doctrineis one which establishes the practical rule of banking policy, that intime of a crisis the lender of last resort should lend freely on goodsecurity at a high rate of interest. Its action implies technically anincrease in the total amount of money, but this is held to beharmless at such times and in no way inflationary, because theadditional cash merely goes into hoards and is not used to increasethe volume of money coming forward in purchase of goods, and solong as the rate of discount is high the amount borrowed is keptwell within these limits, while at the same time deposits areattracted back to the banks. The addition made to cash resourcesby the central bank in time of crisis allays the tendency to a panicand slows up what would otherwise develop into a chronic processof liquidation.

If crises are bound to occur under either system this becomes,according to the one school, in itself adequate reason for preferringa central banking organisation to a free-banking one. The free-



banking school has sometimes opposed to this the counter-argument17 that if a central or other institution regularly gives aidwhenever the money market is in difficulties, the knowledge thatthis is continually to be relied upon will become part of the dataanticipated by the commercial banks and will itself be a reason whythey will expand their lending operations beyond the limits whichwould give them the margin of safety consistent with a dependenceentirely on their own resources, and if distress support ceased tobe given and banks were allowed to crash if they were unable tokeep going by self-help, the disorders giving rise to a crisis wouldin future not occur. This counter-argument is weakened if we haveto assume that, given the fact that there will be some banks whoexpand credit unwisely until their solvency becomes suspect, thenon-expanding banks cannot escape entirely from the evil impact ofthe policy followed by their less cautious rivals, and if anything inthe nature of a panic starts it is likely to affect all to such an extentthat even the prudent banks may not be able to keep above watersince no bank can be 100 percent liquid. Unless it can be provedthat free banking would entirely eliminate the trade cycle andgeneral runs on the banks, the argument for the lender of lastresort remains a very powerful argument in defence of centralbanking.18

Before proceeding to the fourth and fifth arguments in favour ofcentral banking, we may digress here to consider what was therelation of the arguments we have already discussed to twosubsidiary problems: the prohibition of small notes and thejustification of the exclusion of deposit banking from the stricturesapplied to the note issue.

The arguments we have so. far examined in connection with thenote issue in general were held to apply a fortiori to the case ofnotes of low denomination. Small notes were, in the first place,particularly liable to come into the hands of the poorer and moreignorant classes who were most unable to discriminate betweenthe issuers. In the second place they tend to return less frequentlyto the banks and so are not often put to the test of convertibility,whereas the larger notes not only come back for change but arealso mainly in the hands of those who make and receive largepayments and are most likely to use them in transactions with thebanks. Again, while in normal times small notes are seldomconverted, they become particularly dangerous at the least sign ofalarm, because it is the poorer and more uneducated people whoare the first to “panic.”19 We notice that even Wagner, who was infavour of keeping restrictions at a minimum, thought that theprohibition of small notes might be wise in a free-banking system.



Most of the supporters of restrictions on freedom to issue notesconceded that the same strictures did not need to be applied todeposit banking, and many of them fought enthusiastically forfreedom in this sphere.

Various reasons were offered at different stages in the developmentof currency and credit doctrine as to why deposit banking cameinto another category than that of the issue of notes. Thedistinction was first supported on the grounds that notes weremoney and deposits subject to check were not, and therefore theydid not have the same effect on prices. Other writers based it onthe less fallacious reasoning that the public had less choice inaccepting notes than in accepting checks. Later, it was attributedto the circumstance that the creation of deposits is more subjectthan that of bank-notes to the redemption check via interbankclearings. Finally, it has been justified by reference to theproposition that the control over the creation of bank-notes givesthe central bank indirect control over the amount of deposits aswell, since central bank money constitutes the cash reserves of thedeposit banks.

Two subsidiary arguments in favour of central banks have becomeprominent, especially in post-war years. The first of these claimsthat we must have some central monetary authority in order thatwe may pursue what is called a “rational” monetary policy.

The policy of the central bank is no longer conceived to beautomatic in the manner envisaged by the founders of the currencyschool. The volume of circulating media does not change inresponse to specie movements. These may be ignored or offset asthe central bank management thinks fit. With the aid of discountrate and open market operations it adopts an active policy ofincreasing or decreasing the cash reserves of the money marketand the total volume of credit. We retain in this country merely asemblance of the principle underlying the Act of 1844. If thedeposits the Bank creates cause, in the course of time, a demandfor notes which it cannot supply under the fixed fiduciary issue, itcan rely on a suspension of Peel’s Act; if they cause an increase inforeign claims and a drain of its gold reserves, it can go off the goldstandard.

Out of the realisation of the central bank’s power to determine thevolume of credit there arose the notion that it should consciouslydirect monetary policy along “scientific lines.” The question thenarises: What is to be the criterion of this “scientific” management?The criterion which has so far usually been adopted, namely, that ofthe stability of the general price level, has been suspect in theoryand just as unfortunate in practice. Although the contributions of



Mises, Hayek, Keynes, Myrdahl20 and others have gone far toelucidate the forces at work, we have yet to wait for theformulation of some other criterion in clearly delineated enoughterms to allow of its adoption as a rule of monetary policy.Meanwhile, it is the efficacy of central bank control rather than theobjective so far followed that is most called into question bymonetary reformer, and consequently the demand is raised for theconcentration of still more control in the hands of the centralmonetary authority by extending its direct control to deposits aswell as the note issue.

The other argument is of a similar nature. It looks on the centralbank as an essential instrument for securing international co-operation in monetary policy. In the past, at least, this has usuallymeant arriving at understandings in the field of discount policy toobviate the necessity of a deflation in a country which, under therules of the gold standard, should undergo a decrease in its moneyincomes. As such it is regarded as an essential link in pricestabilisation policy. Thus Mr. Hawtrey21 conceives of it as a meansof surmounting the difficulties raised by the circumstance thatstable exchange rates between countries may not always becompatible with a stable price level within each separate country. Ifthe level in one country A is to be kept stable, it may be necessaryto have a rise in country B, or, alternatively, if B’s price level is tobe kept stable, there may have to be a fall in country A. He looks toarrangements between central banks to determine how “thesedepartures from the norm” can best be distributed between thecountries concerned.

The securing of international co-operation was hinted at as beingthe most important modern function of central banks both at theBrussels Conference in 1920.22 and at the Genoa Conference in1922.23 Central bank leaders see it in the same strong light, andwe find Mr. Montagu Norman describing his efforts to bring aboutco-operation among the central banks of the world as one of histwo main tasks during recent years.24 That his efforts did not gounrecognised is evidenced by the widespread opinion that theforcing down of discount rates by the Federal Reserve in the latterhalf of 1927 took place under persuasion from representatives ofother central banks.25 But more impressive results are evidentlyenvisaged by those who deplore the fact that co-operation has notyet succeeded in going much beyond “an ad hoc agreement thatcertain steps may be taken about rates.”26 If it were really truethat central bank co-operation is directed towards the observationof the rules of the “gold standard game,” as some of its disciplespretend,27 there would, even if there were nothing to be said in itsfavour, be at least nothing to be said against it. In effect, however,



the theory underlying it amounts to a complete negation of theprinciples under which the international gold standard works.

Less objectionable would seem to be that aspect of international co-operation which has had a long history of practical application andwhich is an extension of the concept of the “lender of last resort” tothe international sphere. Where the banking system of any countryis faced by a run of foreign depositors, the assistance which can berendered by the central bank of that country to the deposit banksmay not be able to go very far on the basis of its own gold reserves,and it has not infrequently happened in the past that a foreigncentral bank or group of foreign banks has lent funds to the centralbank in difficulties. Mr. Hawtrey looks forward to the time whenthis function of the international lender of last resort will beassumed by the Bank for International Settlements.28

The two arguments last mentioned have become in our time thealmost exclusively motivating reasons for the foundations of newcentral banks. A clear example of this is to be found in therecommendations of the recent Royal Commission on Banking andCurrency in Canada.29 They are characteristic of the change thathas taken place in the theory of central banking. The classicaltheory of central banking was that it should make monetarymovements as far as possible automatic. The modern theory is tosubstitute “intelligent planning” for automatic rules. To those whowould prefer to place their trust in semi-automatic forces ratherthan in the wits of central bank managers and their advisers, freebanking would appear to be by far the lesser evil. Banks whichhave not the possibility of abrogating their liability to pay theirobligations in gold cannot go very far wide of the path followingmovements in their gold reserves.

Any attempt to make a final evaluation of the relative merits ofalternative systems of banking must look primarily to thetendencies they manifest towards instability, or more particularly tothe amount of causal influence they exert in cyclical fluctuations.Most modern theories of the trade cycle seek the originating forceof booms and depressions in credit expansions and contractionswith the banks as the engineering agencies. A more comprehensiveview considers that these movements are not features exclusivelyof the banking system, but that, while liable to be aggravated bythe banking system, they will occur under any monetary system.

It was apparently assumed by writers of the currency school30 thatwith a purely metallic currency, and therefore with a strictoperation of the currency principle, there would be nodisequilibrating monetary factors. In this connection there wassome valid point in the classical theory of the hoards. The banking



school held that even in a purely metallic currency where there isno creation of bank credit, the effective circulation will still varywith the movements of money in and out of what they called thehoards.31 Modern theory essentially generalises this concept tocover all changes in the rate of spending cash balances in general,and comes to the conclusion that it is possible that thesefluctuations in the effective circulation which come about as theresult of spontaneous action on the part of the public may besufficient to generate cyclical fluctuations in business activitywithout the guilt of the banks.

It is difficult to judge how great would be these primary changes inthe public’s demand for cash: the movements which have recentlymade such a marked impression on the financial structure havearisen largely as secondary movements consequent on priordisturbances in the banking system. They were caused eitherdirectly or indirectly by credit expansions and contractions. Thenon-existence of a banking system would eliminate the very largeelement caused by panic hoarding, but there would remain suchfactors as integrations and disintegrations in industry, changes inpopulation, alterations in the attitude of the public towardsdifferent risk distributions of their assets. If these “natural”accelerations and decelerations in the turnover of balances arelikely to reach appreciable dimensions, then it may become part ofthe object and usefulness of banking to counteract them, and afiduciary issue (whether in the form of uncovered notes or of checkdeposits) may, we find, be a necessity, if monetary factors are to bekept neutral.

How to discover a banking system which will not be the cause ofcatastrophic disturbances, which is least likely itself to introduceoscillations and most likely to make the correct adjustments tocounteract changes from the side of the public, is the most acuteunsettled economic problem of our day.

There is not much doubt that the present banking system is activelyresponsible for disturbances. The more difficult task is todetermine out of what particular features of the system they arise.But it seems to be an indisputable fact that the major fluctuationscome from changes in the amount of cash provided by the centralbanks. We find that the commercial banks keep relatively stablereserve proportions and that their lending activities follow fairlyclosely (except in the pit of the depression) movements in centralbank money.32 These movements are, of course, magnified by thecoefficient of expansion, say, ten times, but central bank policy isalways conducted with the knowledge of this fact in mind. It ispropositions of this kind which seem to lend support to the theory,most recently put forward by Mises,33 that fluctuations, while not



being entirely eliminated, would be much reduced under freebanking. And it is undoubtedly true that such a system is much lesscapable of monetary manipulation than a system of central control.

But whatever may be our verdict as to the comparative outcome ofthe two systems in terms of stability it is unlikely that the choicecan ever again become a practical one. To the vast majority ofpeople government interference in matters of banking has becomeso much an integral part of the accepted institutions that tosuggest its abandonment is to invite ridicule. One result of thisattitude is that insolvency in the sphere of banking has wonexception from the rule applied in other lines of business that itmust be paid for by liquidation, and it is important also to point outthat since the laws of bankruptcy have almost never been strictlyapplied to banking we should be diffident of drawing the conclusionthat actual experiences prove the unworkability of free competitionin banking.

Such pleas as are occasionally made in our day for free trade inbanking come from sources which do not commend them. They arethe product of theories of “money magic.” Their demand for freebanking is based on the notion that it would provide practicallyunlimited supplies of credit and they ascribe all industrial andsocial evils to deficiencies of banking caused by bank monopoly.34As a matter of practical policy the tendencies are all in thedirection of increased centralisation. When the choice was made inthe nineteenth century in favour of controlling the note issue,deposit banking was for various reasons left “free.” At the presenttime there are signs of an approaching extension of the control todeposits. This would secure the final concentration of monetarypower in the hands of the central authority and would be theconsistent outcome of central bank philosophy and the currencydoctrine. There are already strong movements in this direction inboth Germany and the United States. In the United States it is asyet only a plan,35 in Germany it is an accomplished fact.




Appendix

On The Working Of The “AutomaticMechanism” Of Credit ControlIn order to make clear the argument on pp. 178-184 of the lastchapter we append the following arithmetical example:




1.

THE NOTE–ISSUING CASEAssume that there are two banks (or groups of banks), A and B.Both carry on the same volume of business in the first instance.Each lends 10,000 and has 10,000 loans falling due on eachsettlement day.

A now increases its lending on a given day by 10,000 and all theseextra loans fall due for repayment four clearing periods later, sothat there are three clearings in between. Assume further (a) that ifB draws gold from A, B does not immediately increase its note issueto the extent that would bring its reserve ratio back to its formerlevel, but only to the extent necessary to replace the notes thathave not come in as usual, but have stayed out in the circulation(this merely makes it possible for it to lend currently the sameamount as before); (b) that A correspondingly reduces itsoutstanding note issue by the amount of the loss of gold, that is, bythe amount of extra notes it has returned to it by B through theclearings. Then the total note issue outstanding of A and B togetherremains the same throughout the period under consideration.

Original PositionA. B.

Notes 40,00040,000Gold 4,000 4,000Loan Repayments10,00010,000

A receives 5,000 of its own notes and 5,000 of B’s.

B receives 5,000 of its own notes and 5,000 of A’s.

Notes are therefore cleared without any transfer of gold.

Position at First Clearingafter A’s Expansion

A. B.Notes 50,00040,000Gold 4,000 4,000Loan Repayments10,00010,000





B draws 1,111 gold from A.

Second ClearingA. B.




B draws 826 gold from A.

Third ClearingA. B.




B draws 682 gold from A.

Fourth ClearingA. B.




B loses 4,205 gold to A.

At the end of thefourth clearingthe position is:

A. B.Notes51,58638,414Gold 5,586 2,414




2.

THE DEPOSIT CREDIT CASEWe may assume in this case that the recipients of checks paid outby the borrowers of the additional 10,000 pay these checks intotheir banks for collection immediately. It is reasonable to suppose,unless there is an uneven distribution of deposit business betweenthe two banks, that half of these checks will be paid into each bank.

Original PositionA. B.

Deposits40,00040,000Cash 4,000 4,000

Position at FirstClearing

A. B.Deposits50,00040,000Cash 4,000 4,000

B receives 5,000 in checks drawn on A against which there is nocounterclaim of A on B; B therefore claims 5,000 in cash from A.

The position after the firstclearing is alreadyuntenable for A:

A. B.Deposits45,000 45,000Cash −1,0008,000 + 1,000

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[1. ]Biographical and bibliographical facts come mainly fromarticles assembled by Ente per gli Studi Monetari, Bancari eFinanziari “Luigi Einaudi,” 1984, especially those by RosariaGiuliani Gusman and Gottfried Haberler; from Verena Veit-Bachmann’s article on Friedrich Lutz; and from a letter andenclosure dated 26 June 1989 written by Mrs. Brenda K. Fowler,the sister of Vera Smith Lutz. l am grateful to Mrs. Fowler for goingto the trouble of preparing her valuable information.

[2. ]See Anna J. Schwartz (1987), under the reference listing thatfollows, for a discussion of different schools. Subsequent in-textcitations are to references in this listing.

[3. ]The only recent challenge is that made by Mises in his“Geldwertstabilisierung und Konjunkturpolitik,” 1928.

[4. ]Under complete freedom good banking depends not only on theability of the bankers, but also on the public’s having sufficientknowledge and experience to detect the good from the bad, thegenuine from the fraudulent.

[5. ]In practice the liabilities on note issue were not restricted tothis amount. See Feavearyear, “The Pound Sterling,” p. 118.

[6. ]See MacCulloch, “A Treatise on Metallic and Paper Money andBanks,” p. 42.

[7. ]The issue of notes for sums less than £1 had been forbidden in1775 and the issue of notes for less than £5 in 1777.

[8. ]“Considerations on the Currency and Banking System of theUnited States,” 1831, P. 47.

[9. ]“La Liberté des Banques,” 1866, p. 301.

[10. ]See “Parliamentary Papers, Reports from Committees, 1819,”Vol. III., Report No. 338.

[11. ]“The General Principles and Present Practice of Banking inEngland and Scotland.”

[12. ]See his letter to the Governor of the Bank of England (1826),printed by J. Horsley Palmer in his “Causes and Consequences ofthe Pressure on the Money Market,” 1837.



[13. ]All these banks were at the beginning unlimited liabilitycompanies; limited liability was not allowed them before 1858.

[14. ]It also secured the final abolition of the Usury Laws. The Bankhad been exempted from them so far as borrowing was concerned,in 1716, but it was not until 1833 that it was free to charge whatrates it thought fit for loans it granted itself.

[15. ]“The Causes and Consequences of the Pressure on the MoneyMarket,” 1837.

[16. ]Report of the Committee of Secrecy on the Bank of EnglandCharter,” 1831-2.

[17. ]Reflections suggested by a perusal of Mr. J. Horsley Palmer’spamphlet on the “Causes and Consequences of the Pressure on theMoney Market,” 1837.

[18. ]See his “Remarks on the management of the circulation andon the condition and conduct of the Bank of England and theCountry Issuers during the year 1839.”

[19. ]See Feavearyear, “The Pound Sterling,” p. 256.

[20. ]Their chief claims were the following: (a) to be allowed todiscount paper payable not only in their own town, but also in anytown having a bank; (b) to be able to discount bills having twosignatures only, the present requirement being three; (c) to beauthorised to issue notes for 100 frs.

[21. ]Up till 1847 the Bank had not been allowed to issue notes inParis for less than 500 frs. At the Comptoirs in the provinces itcould, like the departmental banks, issue them for as low as 250frs. In 1847 the same minimum denomination was made to apply toParis, where provincial notes for that amount had in any case beencirculating previously.

[22. ]“La Banque Libre,” 1867.

[23. ]In times of strain it always meant that some form of rationinghad to be resorted to. M. Rouland, Governor of the Bank of France,remarked before the Commission of Enquiry (1865) that when theBank kept its rate of discount fixed it often had to reject demandsfor discounting at that rate in considerable proportions. So hestates that in 1812, 30 percent of the total demands were rejected,in 1832, 14 percent and in 1841 and 1842, 6 percent. See“Dépositions de MM. les délégués et les régents de la Banque deFrance,” p. 116.



[24. ]At the renewal of its charter in 1857 it had acquired the rightto issue notes for 50 frs. It actually first took advantage of this in1864, at the time of the Bank of Savoy affair.

[25. ]The most common rule was that note issues should not exceeddouble the amount of the bank’s capital. Such provisions were,however, usually purely nominal; the limits they imposed werenever likely to be reached. See Gallatin, “Considerations on theCurrency and Banking System of the United States,” 1831, p. 65.

[26. ]Only in England and Scotland were joint stock companiesgenerally subjected to unlimited liability. In America, as well as onthe Continent, the principle of limited liability became the generalrule right from the beginning.

[27. ]See Carey, “The Credit System of France, Great Britain andthe United States,” 1838, p. 68.

[28. ]Founded in 1791. The Federal Government had subscribedpart of the capital and pledged itself not to grant a charter to anyother bank for the next twenty years.

[29. ]The New England banks fulfilled their engagements. All thebanks to the south and west failed. See Gallatin, “Considerations onthe Currency and Banking System of the United States,” p. 42.Most failures in these and the following years took place whereentry into the banking trade was most restricted. Carey givesfigures of failures from 1811 to 1830. In New England as a wholethe number of banks between 1811 and 1830 averaged 97 and thetotal failures were 16. In New York the banks averaged 26 andthere were 11 failures. In Pennsylvania there were 29 banks with19 failures, and the proportion of loss increases as you go furtherto the west and south.

[30. ]Gallatin estimated that within the first fifteen months of thesuspension of specie payments, their note issues increased by 50percent. Op. cit., p. 45

[31. ]“Considerations on the Currency and Banking System of theUnited States,” p. 46.

[32. ]See Gallatin, “Suggestions on the Banks and Currency of theSeveral United States,” p. 36.

[33. ]See Gallatin, op. cit., p. 49.

[34. ]Started in 1819.

[35. ]Established in 1829.



[36. ]The fund was finally wound up in 1866.

[37. ]This was yet another occasion when the penalty of liquidationfor suspension went to the winds. Under the 1846 Constitution ofNew York State it was forbidden to the Government to pass any lawdirectly or indirectly sanctioningsuspensions of specie payments,but in the 1857 crisis the authorities refrained from selling out thestocks deposited by the suspending banks and withdrawing theirnotes; the Courts in New York distinguished between what theycalled momentary suspensions of specie payments and realinsolvency.

[38. ]1855.

[39. ]The notes were lawful money and legal tender in payment ofall debts, public and private, within the United States, except forduties on imports and interest on the public debt, which wereexpressly made payable in coin.

[40. ]This chapter is based mainly on the account given by W. Lotz“Geschichte und Kritik des Deutschen Bankgesetzes, vom 14 März,1875.”

[41. ]In the more modern sense, that is, of discounting and noteissue as opposed to the kind of business carried on by the earlyGiro banks.

[42. ]Cf. H. Schumacher, “Geschichte der deutschen Bankliteraturim 19Jahrhundert” in Schmollers Festschrift, “Die Entwicklung derdeutschen Volkswirtschaftslehre im 19 Jahrhundert,” Pt. VII.

[43. ]In 1765 Frederick was unable to obtain the private capital;otherwise he would have made it a private joint stock bank.

[44. ]Viz., the moneys of wards, courts and charity institutions.

[45. ]The latter had royal aid at its foundation, and was bolsteredup by the Government on several other occasions at a later date.

[46. ]This was the first note-issuing bank to be set up in Bavaria,but the Royal Bank of Nürnberg, a non-note-issuing bank, datedfrom 1780.

[47. ]The “Dritteldeckung” (cash reserve of one-third), which fromthis time on wards was a common provision in the laws on Germanbanks of issue, seems to have been the adoption by legalprescription of the conventional practice said by Horsley Palmer tohave been followed by the Bank of England before the Commissionof 1832 in England. Palmer’s pamphlet on the policy of the Bank of



England prior to the crisis of 1836-7, which we mentioned in aprevious chapter, was translated into German under the title “DieUrsachen und Folgen der Wirksamkeit der Bank von England indem Zeitraume vom 10 Oktober 1833 bis 27 Dezember, 1836”(1837).

[48. ]As in the ErsteVereinigte Landtag in 1847.

[49. ]The Stettin Bank was allowed to retain its interest-bearingdeposits.

[50. ]The total result of all the concessions even up to 1857 wasthat in that year there were in Prussia nine note-issuing banks,including the Bank of Prussia.

[51. ]It started the practice of lending out part of its deposits oncurrent account. Much of the progress in Prussia during theseyears had been due to the efforts of one man, David Hansemann. Itwas under his leadership as President of the Bank that the PrussianBank changed its policy. He had also been responsible as FinanceMinister for obtaining the 1848 concessions for the formation ofprivate note-issuing banks and for securing the royal consent to thefoundation of the Schaffenhausen’schen Bankverein as a joint stockcompany. It was again he who, a few years later, founded theDisconto-Gesellschaft.

[52. ]Although there were still in 1858 only thirty Zettelbanken intwenty States.

[53. ]Notable exponents of this view were Tellkampf and Geyer. SeeChapter IX.

[54. ]Both Tellkampf and Michaelis took part in the drafting.

[55. ]“The General Principles and Present Practice of Banking inEngland and Scotland: with Observations on the Justice and Policyof an Immediate Alteration in the Character of the Bank ofEngland, and the Measures to be pursued in order to effect it.”

[56. ]See J. Horsley Palmer, “Causes and Consequences of thePressure on the Money Market,” 1837.

[57. ]See “Political Economy Club: Minutes of Proceedings,” Vol.Vl.,February 6th 1826 (p. 28).

[58. ] Ibid., May 4th, 1829 (p. 33); January 13th, 1831 (pp. 220-1);March 1st, 1832 (p. 38 and pp. 231-2); May 3rd, 1832 (p. 39).



[59. ]“Observations on Paper Money, Banking and Overtradingincluding those parts of the evidence taken before the Committeeof the House of Commons which explained the Scotch System ofBanking.”

[60. ]Committee of the House of Commons on Scotch Banking.

[61. ]Op. cit., pp. 86-87.

[62. ]Op cit, p. 88.

[63. ]“Historical Sketch of the Bank of England with anExamination of the Question as to the prolongation of the exclusiveprivileges of that Establishment,” 1831.

[64. ]“A Plain Statement of the Power of the Bank of England andthe Use it has made of it; with a Refutation of the objections madeto the Scotch System of Banking, and a Reply to the HistoricalSketch of the Bank of England,” 1832.

[65. ]It would be more practical to assume that the proportions inwhich notes are returned to each bank are the same as theproportions existing between the circulations outstanding of thedifferent banks.

[66. ]0p.cit., pp. 8-9. “It is said by those who are hostile tointerference that coins are legal tenders whereas notes beingdestitute of that privilege, those who suspect them are at liberty torefuse them; but whatever notes may be in law, they are in manydistricts practically and in fact legal tenders, and could not berejected without exposing the parties to much inconvenience. Itshould also be observed, that labourers, women, minors and everysort of person, however incapable of judging the stability ofbanking establishments, are dealers in money and are consequentlyliable to be imposed upon.”

[67. ]Presumably notes for smaller sums are likely to be subjectedto less careful scrutiny than notes involving larger sums.

[68. ]“Considerations on the Currency and Banking System of theUnited States,” 1831.

[69. ]The figure he suggested was that loans should not extendbeyond twice the amount of bank capital. This would in itself act asa check on issues, but he recommended that in addition thereshould be a specific restriction of the note issue to two-thirds of thebank’s capital.



[70. ]The bond deposit system proved, in fact, later, that it was farfrom adequate.

[71. ]0p cit, p. 94.

[72. ]This corresponded more or less to what we should now callthe method of loan by overdraft.

[73. ]Op.cit, p. 95.

[74. ]Op cit., p. 31.

[75. ]“Checks differ from bank issues in that the bank-note is takenin payment solely from the general confidence reposed in thebanks, the check from the special confidence placed in the drawer.”See Gallatin, “Suggestions on the Banks and Currency of theSeveral United States, etc.,” 1841, p. 13.

[76. ]“Remarks on Currency and Banking,” 1833.

[77. ]Op cit., pp. 27 and 42.

[78. ]Op cit., pp. 25-26.

[79. ]Op.cit., p. 58.

[80. ]From his pamphlet entitled “Further Reflections on the Stateof the Currency and the Action of the Bank of England,” 1837, p.49.

[81. ]At least by 1840.

[82. ]“History of Prices,” 1838, Vol. III., p. 206.

[83. ]“The History of Banks to which is added a Demonstration ofthe Advantages and Necessity of Free Competition in the Businessof Banking,” 1837.

[84. ]“The Credit System in France, Great Britain, and the UnitedStates,” 1838.

[85. ]He says that from the first institution of banks in Americauntil 1837 the failures had been less than those of England in thethree years 1814, 1815 and 1816.

[86. ]Op. cit, p. 89. Italics ours.

[87. ]Op. cit, pp. 80-82.



[88. ]Op. cit, pp. 57 ff.

[89. ]P. 57 n.: “The loans of banks to individuals are temporary, butas regards the Community at large they may be deemedpermanent.”

[90. ]P. 59.

[91. ]Treatise on Money and Banking,” 1839.

[92. ]Op. cit., p. 137. Italics in the original.

[93. ]“Suggestions on the Banks and Currency of the SeveralUnited States in Reference principally to the Suspension of SpeciePayments,” 1841.

[94. ]Op.cit., p. 69.

[95. ]Opcit., p. 70.

[96. ]He wrote a series of four articles on “Banking and Currency”in the Dublin University Magazine in 1840. The argument referredto comes in the second of these articles (February, 1840).

[97. ]A and B may be equally well taken to denote two groups ofbanks, one of which is conservative and the other expansive.

[98. ]Longfield assumes that the circulation must fall back to theprevious level; but this makes no difference to the main argument.

[99. ]Published also in book form, “Capital, Currency and Banking,”1847.

[100. ]See Article Ill.

[101. ]“Capital, Currency and Banking,” p. 282.

[102. ]“Theory and Practice of Banking,” 1855.

[103. ]“It is... not difficult to see that it becomes a most essentialthing to the continued prosperity of a country that its floatingcapital, on which the continued reproduction of commodities ofeveryday use depends, as well as the continuous employment oflabour, should not be withdrawn from those necessary purposesand converted into fixed capital in a greater degree than thesurplus accumulation of the country, after replacing the whole fundneedful to continue the production of such commodities... willadmit. If the floating capital of the country is thus misdirected intofixed capital, it is quite plain that the ultimate result must be, that



as the labour employed in the works representing the fixed capitaldoes not reproduce the commodities which are consumed insupporting it, or any commodity which can be exchanged eitherwith the home or foreign producers of such commodities, they mustbecome scarce and dear, and ultimately the fund for theemployment of labour must be diminished.

“It is quite true that for a time, while the process of the conversionof floating into fixed capital was proceeding, there would be amomentary appearance of great prosperity.... The production ofcommodities required for daily use would be unequal to theconsumption; they would continue to rise in price... The ultimateeffect of such a disturbance or misdirection of the floating capitalof the country would be to create a great scarcity of it which will beevinced by the high rate of interest.” (Op.cit., pp. 127-8.)

[104. ]Speaking of the railway development and the conversion offloating capital into fixed which this entailed, Wilson says that it isclear that “the first effect of this process would be to render capitalscarce and in proportion to raise the rate of interest; and that thenext effect would be by rendering commodities of consumptionscarce, to increase their demand, and to afford thus a strongerinducement to continue capital in its existing channel than to divertit into a new one.” The inevitable result would be that a greatmajority of the railway schemes must be abandoned (op. cit., p.148).

[105. ]Viz., Geyer. See Chapter IX.

[1. ]Lettres sur l’Amérique du Nord,” 1836. “A long time mustelapse before we can enjoy in France a system of credit asextensive as that which exists in England and the United States. Weare in that respect in a state of barbarism” (Vol. II., p. 248).

[2. ]Op.cit., Letter W.

[3. ]Translated under the title “Traité des banques et de lacirculation,” by L. Lemaitre, 1840.

[4. ]“Du Crédit et de la Circulation,” 1839.

[5. ] Op cit. , Chapter III.

[6. ]“Le Crédit et la Banque.”

[7. ]Quoted by Wolowski, “La Question des Banques,” pp. 192, 176ff.



[8. ]See an article entitled “D’une Réforme du Régime Monétaireen France” in La Revue desDeux Mondes, VoI. III., (1844).

[9. ]“Du Crédit et des Banques,” 1848.

[10. ]“Traité Théorique et Pratique des de Operations Banque,”1852.

[11. ]A view that was also supported later (1862) by Juglar in his“Des Crises Commerciales et leur Retour Périodique en France, enAngleterre et aux Etats-Unis,” in which, while noting the markedcorrelation between the increase in the volume of discounts and ofthe note issue on the one hand, and in prices and the diminution ofthe metallic reserves on the other, he regards such movements asthe results of other underlying factors rather than as the causes; hesays: “Les excès de l’émission ne sont pas la cause principale descrises” (p. 34).

[12. ]“De la Monnaie, du Crédit et de L’Impôt,” 1853, p. 237.

[13. ]See the report in La Revue des Deux Mondes, 2me série, Vol.XXI., (1857), p. 471.

[14. ]See the report in Le Journal des Economistes, 2me série, Vol.XIV., (May, 1857).

[15. ]He was the French negotiator and therefore Cobden’scounterpart in the 1860 Commercial Treaty between France andEngland.

[16. ]“Réorganisation des Banques: Légalité et Urgence d’uneRéforme,” 1861; “Réorganisation du systéme des banques: Banquede France, Banque de Savoie,” 1863, both ascertained later to havebeen written by the Pereire brothers.

[17. ]See also Gustave Marqfoy, “La Banque de France dans sesrapports avec le crédit et la circulation,” 1862, in which it iscontended that it is the duty of the Bank of France to keep theprice of credit invariable by counteracting by its own lending anytendency to a rise in the rate of interest on the market.

[18. ]“La Liberté des Banques d’Emission et le Taux de L’Interêt” inLaRevue des Deux Mondes, Tome XLIX., January 1st, 1864.

[19. ] “La Banque de France et l’Organisation du Crédit en France”(1864).

[20. ]Opcit., p. 40.



[21. ]Op. cit., p. 73.

[22. ]“Les Banques d’Emission et Escompte” (1864).

[23. ]The low discount rate school in France made frequentreference to the words of Napoleon written to his Minister ofFinance, Mollien, in 1808: “Ce que vous devez dire au gouverneurde la Banque et aux régents, c’est qu’ils doivent écrire en lettresd’or dans le livre de leurs assemblées ces mots: Quel est le but dela Banque de France? D’escompter les crédits de toutes les maisonsde commerce à 4%.”

[24. ]Opcit., p. 10.

[25. ]Op. cit, pp. 127-8.

[26. ]Op. cit., pp. 172-3.

[27. ]Op. cit., p. 6.

[28. ]Op cit., p. 115.

[29. ]Op cit., p. 55.

[30. ]“Encore la Question des Banques,” 1865.

[31. ]“De la Monnaie de Papier et des Banques d’Emission,” 1864.

[32. ]Op.cit., p. 13.

[33. ]Brasseur.

[34. ]“Manuel d’Economie Politique,” Vol. II., 1864, p. 277.

[35. ]Article “Les Banques de France et de Savoie,” in the Journaldes Economistes, 2me série, Vol. 121., January, 1864. See also hisbook, “Les Circulations en Banque ou l’Impasse du Monopole,Emission et Change,” 1865.

[36. ]Article “De la Liberté des Banques” in the above number of LeJournal des Economistes.

[37. ]Articles on “La Liberté’ des Banques” in the Journal desEconomistes, 1864 and 1865.

[38. ]“La Banque de France et les Banques Départementales” in LaRevue des Deux Mondes, April 15th, 1864.



[39. ]See J. B. Vergeot, “Le Crédit comme Stimulant et Régulateurde l’Industrie—La conception saint-simonniene, ses réalisations,son application au problème bancaire d’après-guerre.”

[40. ]Letter in Le Journal des Dêbats, February 4th, 1864.

[41. ]“La Question des Banques,” 1864.

[42. ]“Enquête sur les principes et les faits généraux qui régissentla circulation monétaire et fiduciaire,” 1865-66.

[43. ] “Dépositions de MM. les délégués et les régents de la Banquede France,” pp. 81-117.

[44. ]Op.cit., p. 112.

[45. ]“Le Marché Monétaire et ses Crises depuis Cinquante Ans,”1865.

[46. ]“Mécanique de l’échange,” 1865, and “Contre le Billet deBanque,” 1865, the latter being the evidence he gave before theBanque Enquête.

[47. ]“Le Billet des Banques d’Emission et la Fausse Monnaie” in LeJournal des Economistes, Vol. III., August 15th, 1866.

[48. ]Courcelle-Seneuil, “Le Billet de Banque n’est pas FausseMonnaie” in the same journal, September 15th, 1866. See also aletter by Du Puynode in the same number, a reply by Modeste inthe October number and an article by Mannequin in the Decembernumber.

[49. ]“Etudes sur la Circulation Monétaire,” 1865.

[50. ] Op.cit., pp. 78-80: “Les billets ( ordre et les lettres de changeles effets decommerce proprement dits, les promesses de payer aune date fixe et à une personne désignée, ne peuvent circuler, nousl’avons démornré, qu’entre individus qui se connaissent, il y aexamen du titre cédé, discussion de sa valeur, endos, garantienouvelle et additionelle donnée par le cédant au cessionnaire....Quand ces promesses demeurent impayées à l’échéance, lesdétenteurs se reprochent à eux-mêmes leur imprévoyance ou leurpeu d’aptitude aux affaires.... Ce que nous disons des effets decommerce ordinaires peut s’appliquer exactement aux dépôts chezles banquiers. Nulle raison générale ne pousse les particuliers afaire le dépôt de leurs fonds chez un autre. Le choix parfaitementlibre d’un dépositaire est toujours determiné par desconsiderations individuelles.... Si les billets à vue et au porteur necirculaient comme les autres effets de commerce que dans un petit



nombre de mains, si leur transmission pouvait être précedé d’unexamen détaillée et accompagnée d’une garantie du cédant aucessionaire, les pouvoirs publics n’auraient pas à intervenir pourles réglementer.... Mais chacun sait qu’il n’en est point ainsi.”

[51. ]“La Liberté des Banques,” 1866.

[52. ]Op.cit., p. 62.

[53. ]It would still, even in our day, seem that the note issue is ofthe utmost importance as a budgetary source in time of war.

[54. ]Op.cit., p. 396.

[55. ]“On a Porté l’abus à ce point, que la facilité d’émission dontles banques étaient investies fut pour le gouvernernent la plancheaux assignats; de là résultait bientôt l’insolvabilité de la banque.”Quoted by Wolowski, “La Banque d’Angleterre,” p. 199.

[56. ]Op. cit, p. 392.

[57. ]Op.cit. , p. 414.

[58. ]Op.cit., p. 125: “C’est l’huile qui manque pour graisser lamachine, l’eau qui fait défaut pour alimenter la chaudière; toutesles entreprises s’en ressentiront; les plus solides marcheront avecdifflculté; les moins forts s’arrêteront; les faibles s’éclateront.”

[59. ]“La Banque d’Angleterre et les Banques d’Ecosse,” 1857.

[60. ]“La Banque Libre; exposé des fonctions du commerce debanque et de son application à l’agriculture suivi de divers écrits decontroverse sur la liberté des banques,” 1867.

[61. ]“Ils raisonnent comme s’il était indifférent aux banques defaire faillite, c’est à dire comme si elles devaient être dirigéesuniquement par des personnes décidés à faire une banqueroutefrauduleuse. Il nous semble que les personnes de ce caractère, bienque trop nombreuses, sont une exception dans le mondecommercial, et que ce ne sont pas celles qui commandenthabituellement la confiance publique.”

[62. ]“Du Change et de la Liberté d’Emission,” 1868.

[63. ]“Bericht aus den Vereinigten Staaten Nord Amerika’s überEisenbahnen, Dampfschiffahrten, Banken und andere öffentlicheUnternehmungen,” 1839.



[64. ]“Drei Gegenstände sind es vorzüglich, welchen dieVereinigten Staaten ihren Wohlstand verdanken: die Schulen. . . ;die Banken, 800 an der Zahl, welche jedermann mit LeichtigkeitGeldmittel, seinem Vermögen angemessen, darbieten, und ihn indie Lage setzen, an Spekulationen jeder Art Theil zu nehmen:endlich Eisenbahnen, Canäle und Dampfschiffahrt...” Op. cit., p. 1.

[65. ]“Die Banken,” 1854.

[66. ]Op cit., Vol. I., p. 32.

[67. ] Op. cit., Vol. I., p. 33.

[68. ]Op.cit., Vol. I., p. 73.

[69. ]Op.cit., Vol. I., p. 73. “Die Papier ohne Metallhinlage, dieErhöhung der Preise aller Dinge, sind ein scheinbarerVermögenszuwachs, der genossen und verzehrt wird. Da diesVermögen aber eben nur scheinbar, da es kein Kapital, keinersparter Überschuss, ist, so wirkt sein verzehrter Betrag,schliesslich als ein Deficit zwischen Haben und Soll. Man hatkeinen Vermögenszuwachs, sonder, das alte Vermögen verzehrt.”

[70. ] Op. cit., Vol. I., p. 123.

[71. ]Hunt’s “Merchants’ Magazine and Commercial Review,” Vol.IV., p. 70.

[72. ]“Über die Neuere Entwicklung des Bankwesens inDeutschland mit Hinweis auf dessen Vorbilder in England,Schottland und Nord-Amerika und die französische Société’Générale du Crédit Mobilier,” 1856.

[73. ]He attacks particularly von Gerstner’s views.

[74. ]See also his “Essays on Law Reform, Commercial Policy,Banks, etc., in Great Britain and the United States of America,”1859.

[75. ]“Über die Neuere Entwicklung, etc.,” p. 5.

[76. ]Note that Tellkampf was responsible in co-operation with E. J.Bergius for translating under the title “Geld und Banken” (1859)MacCulloch’s “Treatise on Metallic and Paper Money and Banks,”in which the currency doctrine is defended.

[77. ]“Beiträge zur Lehre von den Banken,” 1857.

[78. ]Op.cit., p. 212.



[79. ]Opcit., p. 233.

[80. ]“Die Geld-und Kredittheorie der Peelschen Bankakte,” 1862.

[81. ]See report of proceedings in the “Vierteljahrschrift fürVolkswirtschaft und Kulturgeschichte,” 1863, Vol. III., pp. 241 ff.

[82. ]This discussion in detail of note cover was a new departure inthe discussion of banking, and was probably due to two factorspeculiar to Germany: firstly, the extreme fluctuations that certainlydid take place in the securities of all the German States, includingPrussia; and secondly, the fatal experiences in the outlying Statesof the attempt to use crédit mobilier assets as note cover.

[83. ]Michaelis says: “Das einzige reelle Sicherungsmittel ist dasbei der Bank stets wache Gefühl der Notengefahr. Man sage daher,so viel Noten als einer Bank jeden Tag zur Einlösung präsentiertwerden, so viel muss sie an dem Tag der Präsentierung unter allenUmständen einlösen, und wenn sie das nicht tut, so ist siebankrott.” See “Vierteljahrschrift für Volkswirtschaft undKulturgeschichte,” 1863, Vol. III., p. 251. It is important that itshould be clear that this does not mean that a bank would never beable to tide over a temporary embarrassment, or, alternatively, thatit would be compelled, in order to be perfectly secure, to keepreserves of 100 percent. It is, indeed, to be expected that thevolume of notes flowing back to any bank will, from time to time,surpass the normal anticipated movement plus a certain allowancefor some margin of deviation for which the bank can be expected toprovide adequate reserves. But if such a surprise demand for cashsuddenly arises and the bank’s position is such as to allow it tomeet all its obligations, provided it had the time to call in loans andso liquidate its position, it will surely be able to borrow for thenecessary period from the market. A bank which is solvent to theextent that it could meet its liabilities within a reasonably shortperiod, but was suffering from insufficient liquidity at the moment,should not experience difficulties in arranging such a loan.

[84. ]Opcit., p. 258.

[85. ]See “Vierteljahrschrift für Volkswirtschaft undKulturgeschichte,” 1865, Vol. II., pp. 206 ff.

[86. ]“Noten und Depositen,” published in Faucher’s“Vierteljahrschrift.”

[87. ]“Nehmen wir an, das alle nebeneinander bestehenden Bankengleich leichtsinnig in der Ausdehnung ihres Notenumlauf wären, sowürde durch solche gegenseitige Abrechnung im Ganzen eine



Kompensation, nicht eine Realisation der Notenversprechungenstaffinden. Da indess die verschiedenen Banken verschiedenenGrundsätze verfahren, so führt diese Abrechnung zurNotwendigkeit barer Ausgleichungen sobald nur eine unter ihnenist, die im Verhältniss zu ihren Umsätzen wenig Noten im Umlaufhat. Denn diese eine empfängt immer mehr fremde Noten alsandere Banken von den ihrigen empfangen haben können...” Article“Noten und Depositen,” pp. 130-131, in Faucher’s“Vierteljahrschrift,” 1865; also republished by Michaelis in his“Volkswirtschaftliche Schriften,” Vol. II., 1873.

[88. ]“Je grösser der territoriale Umlaufsbezirk der Noten einerBank, um so leichter sammelm sich also Notenmassen im Verkehran, auf deren Rückkehr die Bank nicht vorbereitet ist, je kleinerderselbe, um so öfter kommen die Noten in den Fall, gegen Barumgewechselt werden zu müssen, weil sie um so öfter in Händekommen die Zahlungen aus dem Umlaufsbezirk heraus zu machenhaben”—Article above quoted, p. 132. Actually the principle oflimiting the area served by one bank would lead to conditions ofmonopoly rather than of competition. The more natural systemwould be a branch system in which the area over which the notesof any bank circulate is wide and in which branches of differentbanks compete in the same district. If Michaelis’ othercheck—namely, the clearing mechanism which he supposed tofunction between banks in the same district—works, then inter-bank control will not be lacking in effectiveness in such a system.

[89. ]“Banken und Krisen,” 1865.

[90. ]Op. cit., p. 7.

[91. ]Op. cit. , pp. 33 ff.

[92. ]“Die Preussische Bank und die Ausdehnung ihresGeschäftskreises in Deutschland,” 1866.

[93. ]“Volkswirtschaftliche Schriften,” Vol. II., p. 383; the relevantpassage was absent from the article (“Noten und Depositen”) aspublished in Faucher’s “Vierteljahrschrift.”

[94. ]The reason, as Nasse explains, was that Prussian Governmentsecurities were far less stable than English ones, and in case ofneed could often only be realised at a considerable loss. He evensuggested that it might be advisable for the Prussian Bank to investits spare funds in English Treasury Bills.

[95. ]P. J. Geyer, “Theorie und Praxis des Zettelbankwesens nebsteiner Charakteristik der Englischen, Französischen und



Preussischen Bank,” 1867; J. L. Tellkampf, “Die Prinzipien des Geld-und Bankwesens,” 1867.

[96. ]Op.cit., p. 227.

[97. ]See Wagner, “Beiträge zur Lehre von den Banken,” pp. 81-86.

[98. ]“Bankfreiheit oder nicht?” 1871.

[99. ]Especially as Longfield’s argument remained practicallyunknown.

[100. ]A. Wagner, “System der deutschen Zettelbankgesetzgebungunter Vergleichung mit der Ausländischen, zugleich ein Handbuchdes Zettelbankwesens,” 1870-73. C. G. A. Knies, “Geld und Kredit”(two volumes), 1873-79.

[101. ]Op.cit, Vol. I., p. 313.

[102. ]Op.cit., p. 634.

[103. ]Op.cit., p. 357.

[1. ]“The Principles of Currency and Banking,” 1857.

[2. ]Op.cit., p. 70.

[3. ]Neisser has recently used the same argument in his article“Notenbankfreiheit?” in the Weltwirtschaftliches Archiv., October,1930.

[4. ]“Essays on State Tampering with Money and Banks,” firstpublished in the Westminster Review, 1858, and later included inVol. III. of “Essays Scientific, Political and Speculative.”

[5. ]See Fraser’s Magazine, 1868, “The Controversy on FreeBanking between M. Wolowski and M. Michel Chevalier.” BonamyPrice’s own treatment of the problem contributed nothing verynew. See his “Principles of Currency,” 1869.

[6. ]See “Political Economy Club, Centenary Volume,” Vol. VI., p.86.

[7. ]“Theory and Practice of Banking,” 1855.

[8. ]“Foreign Exchanges,” 1861.



[9. ]Article entitled “Seven Per Cent.” in the Edinburgh Review,January, 1865; republished in his “Essays and Addresses onEconomic Questions.”

[10. ]See “Evidence,” Vol. V., p. 559.

[11. ]“The Economy of Capital,” 1864.

[12. ]“Bank Monopoly, The Cause of Commercial Crises,” 1864.

[13. ]Op.cit., p. 41.

[14. ]See his Theory and Practice of Banking,” Vol. I (p. 479 in the1902 edition).

[15. ]“A Plea for the Reform of the British Currency and the Bank ofEngland Charter,” 1861.

[16. ]Op cit., p. 11.

[17. ]“Evidence,” Vol. I., p. 35.

[18. ]See “Evidence,” Vol. V., pp. 592-3. See also his evidencebefore the English Select Committee on the Bank Acts, 1857, Q.2039.

[19. ]See The Economist, February 11th, 1865, p. 158.

[20. ]In Germany the Prussian Bank was not yet a bankers’ bankholding the bulk of the cash of the other banks, and thereforediffered in this respect from the Banks of England and France. SeeNasse, “Die Preussische Bank, etc.,” p. 59.

[21. ]“Lombard Street,” p. 66.

[22. ]See The Economist, September 1st, 1866.

[23. ]See “The Art of Central Banking,” Chapter IV.

[24. ]The fact that in England the Bank does not lend directly to thebanks (by rediscounting) but to the bill brokers is immaterial. Itprovides the bill brokers with the wherewithal to make repaymentsto the banks.

[25. ]See the Select Committee on the Bank Acts, 1857, Q. 2032.

[26. ]They fell from £5,800,000 to £1,200,000 in a week.

[27. ]See The Economist, September 22nd, 1866.



[28. ]See his “Principles of Banking, Its Utility and Economy; withRemarks on the Working and Management of the Bank of England”(2nd Edition, 1867), pp. 1-39.

[29. ]See The Economist, December 22nd, 1866, p. 1488.

[30. ]Ibid., December 8th, pp. 1418-9.

[31. ]“Essays and Addresses on Economic Questions,” 1891. Essayentitled “Our Cash Reserves and Central Stock of Gold.”

[33. ]It has sometimes been supposed, on an analogy with theEnglish system, that by controlling the amount of note issue,control was at the same time established over the total amount ofbank credit created. But the analogy was incomplete. In England,Bank of England notes formed the legal tender cash of the otherbanks. In the case of a National Bank the bank’s own notes werenot legal tender cash. It was liable to pay cash for notes equallywith deposits, and it was against the two together that it had toprovide adequate cash reserves and the numerical relationbetween them was flexible within wide limits. The danger was thatthe banks might overstep these limits and find themselves with alevel of deposits involving a much higher demand for hand-to-handcurrency than they had the means to supply.

[34. ]$3,000,000 up to 1908 and after that $9,000,000.

[35. ]Up to 1874 notes were redeemable at the counter of theissuing bank and at some bank in one of the cities designated asredemption cities. After 1874 they were redeemable at the bank’sown counter and at the Treasury.

[36. ]The date when specie payments were resumed.

[37. ]The Comptroller of the Currency in his report for 1907 (pp.73-4) remarks: “The only way in which bank credits can be properlyprotected from sudden and unexpected calls, when all may beinvolved at the same time, is by a system of note credits which canbe at any time immediately exchanged for the deposit credits. Theyare essentially the same thing, and should be daily and hourly ifnecessary, convertible from one to the other at the option of thecreditor who is the depositor or note-holder. The bank of issueshould be required, and must in self-defence, keep the samereserves against notes as against deposits. If this is done, there isno expansion or inflation when a note is paid out to a depositor andno contraction when a note is returned to the bank for deposit.With a given amount of reserve money a given total of deposits andnotes can be maintained, and it makes no difference to the bank or



anyone else but the customer who uses either at his option,whether the deposit remains in the bank as a credit to be checkedagainst or is taken away in the shape of a circulating note.”

[38. ]Up to 1874 National Banks in New York had to hold in lawfulmoney in their own vaults 25 percent of deposits plus circulation.Banks in other cities designated “redemption” cities or “reserve”cities as they were later called, must also hold 25 percent, but halfof this might be held on deposit in New York. All other banks had tokeep 15 percent, of which three-fifths might be on deposit withapproved banks in any of the “reserve” cities. After 1874 this legalreserve requirement was revised to apply to deposits only and notto note circulation as well. After 1887 Chicago and St. Louis weregiven the position of “central reserve” cities, the same as NewYork.

[39. ]E.g., see “Report of the Comptroller of the Currency,” 1891-2,p. 36.

[40. ]E.g., see Sprague, “Banking Reform,” 1910, p. 68.

[41. ]See Laughlin, “Banking Reform,” pp. 199 ff.

[42. ]It is not likely that banks would deposit with each otherexcept in so far as it might be necessary for one bank to keepbalances in a place where it had no branch for making payments inthat place. The amount of such balances would normally be small.

[43. ]Cf. Sprague, “Crises under the National Banking System”(U.S.A. National Monetary Commission).

[44. ]See U.S. National Monetary Commission—“The IndependentTreasury.”

[45. ]Cf. Parker Willis, “The Federal Reserve System,” Book I.,Chapter 2.

[46. ]It was part of the services of the Federal Reserve System tosecure the payment of checks at par. The twelve Federal ReserveBanks and their branches hold the reserves of the member banks,and these act as clearing balances. Checks can be presented at thenearest Federal Reserve Bank, and if the check is drawn on a bankwhich is a member of the same Federal Reserve district, funds arealready available. Where checks move out of the district, theFederal Reserve Bank pays the cost of any necessary currencyshipments. The system also exerts pressure on non-member banksbecause Federal Reserve Banks will not collect checks on bankswhich refuse to clear at par.



[47. ]See “Report of the Comptroller of the Currency,” 1907, pp.71-79.

[48. ]See, for example, “The Discount System in Europe,” by PaulM. Warburg (U.S. Monetary Commission). See also “Interviews onthe Banking and Currency Systems of England, Scotland, France,Germany, Switzerland and Italy” (U.S. Monetary Commission).

[49. ]It must be understood that the use of the term “free banking”in the subsequent analysis is not synonymous with that particularsystem of so-called free banking which was put into practice in theUnited States of America in the middle of last century. As waspointed out in the previous chapter, the American system wascharacterised by certain features which render it quiteinappropriate as an example of the working of free banking in themore general sense.

[50. ]Cf. W. Scharling, “Bankpolitik,” pp. 337-8.

[51. ]Cf. footnote 32 on p. 194 of this chapter.

[52. ]See p. 179 ff.

[53. ]There seems to be no generally recognised term to distinguishother banks from the central bank. We shall here use the term“commercial” to describe all banks other than the central bank.

[54. ]Professor Mises has recently defended free banking alongthese lines in his “Geldwertstabilisierung und Konjunkturpolitik,”1928. Professor Neisser has, in reply to Mises, taken up thecounter argument that the “automatic mechanism” of credit controldoes not, in most circumstances, work. See his article“Notenbankfreiheit?” in the Weltwirtschaftliches Archiv. , October,1930.

[55. ]A case considered by Michaelis. See his article, “Noten undDepositen” in Faucher’s “Vierteljahrschrift,” 1865, p. 132.

[56. ]See Chapter VII., p. 85 ff.

[57. ]It is immaterial to the general conclusion what assumption wemake regarding the way in which the increased lending takesplace. We may assume (a) that A gives out all the additional loansat the same date, and that they are all of the same échéance; (b)that it gives them all out at the same date, but that they aredistributed over different periods of échéance; or (c) that itincreases its loans gradually over a period of time. In all cases Areceives back sooner or later the reserves it previously lost. See theillustration in an appendix to this chapter [pp. 197-200].



[58. ]The same principles apply in the case of an accretion of cashto one bank and the demonstration (cf. Phillips, “Bank Credit”) thatthe bank in question cannot expand its loans to anythingapproaching the extent represented by the amount of liabilities theadditional reserves would support on the basis of the old reserveratio, because withdrawals of cash will take place to other banks.

[59. ]Neisser seems to have neglected this factor, although hewould need to assume it in order to prove that there is a basis fordistinction between the check case and the note case; cf. hisarticle, pp. 454-5.

[60. ]Cf. “U.S. National Monetary Commission, Interviews on theBanking and Currency Systems of Canada,” p. 70.

[61. ]See p. 174 of this chapter.

[62. ]See Neisser, “Notenbankfreiheit?” in the WeltwirtschaftlichesArchiv., October, 1930, pp. 449-50. Also Carl Landauer,“Bankfreiheit?” in Der deutsche Volkswirt, September 7th, 1928.

[63. ]The only chance the minority have of escaping is if they havebeen able to select their assets so carefully that they are easilyrealisable even in the crisis, and if their more liquid position issufficient to retain the confidence of the public, so that instead oftheir having deposits withdrawn they actually receive new depositstransferred to them from other banks.

[64. ]Going off the gold standard assists the commercial banks in adirect way, as it no doubt did in this country in 1931. Thewithdrawal of balances to abroad, in so far as it takes place via anexport of gold, sees a reduction in the reserves of the banks at theBank of England unless the latter is in a position to offset, which itcannot do if the external drain of gold is exceptionally heavy. If itgoes off the gold standard there is no need for any offsetting. Theexporter of capital cannot withdraw gold from the Bank; he mustbuy foreign exchange at an enhanced rate, and there is merely atransfer between deposits at the banks from his account to theaccount of the seller of foreign exchange and the bankers’ balancesat the Bank of England suffer no net change.

[65. ]See Mises, “Geldwertstabilisierung und Konjunkturpolitik,”pp. 62-63.

[66. ]The case might be analysed along Pigovian lines (see“Economics of Welfare,” 4th Edition, Part II., Chapter IX., Section10) as one where uncompensated damage is inflicted by the guilty



banks on their innocent rivals, and as such giving grounds for somekind of intervention.

[67. ]See, for example, Horsley Palmer’s evidence before the 1832Commission, Q. 273, where he objects to £1 notes on thesegrounds.

[68. ]L. von Mises, “The Theory of Money” and“Geldwertstabilisierung und Konjunkturpolitik”; F. A. von Hayek,“Monetary Theory and the Trade Cycle” and “Prices andProduction”; J. M. Keynes, “Treatise on Money”; G. Myrdahl, “DerGleichgewichtsbegriff als Instrument der geldtheoretischenAnalyse,” and T. Koopmans, “Zum Problem des ‘neutralen’ Geldes,”in “Beiträge zur Geldtheorie,” edited by F. A. von Hayek.

[69. ]See “Monetary Reconstruction,” pp. 144-5.

[70. ]International Financial Conference.

[71. ]International Economic Conference.

[72. ]“MacMillan Committee, Minutes of Evidence,” 3317.

[73. ]See “Committee on National and Federal Reserve Systems,”U.S.A., 1931, pp. 162, 213-14.

[74. ]“MacMillan Committee, Minutes of Evidence,” 6720 (Sir OttoNiemeyer).

[75. ] Ibid. , 1597 (Sir Robert Kindersley).

[76. ]R. G. Hawtrey, “The Art of Central Banking,” p. 228.

[77. ]1933. See the Commission’s Report, pp. 62-64.

[78. ]Particularly Tellkampf and Geyer.

[79. ]See, e.g., Fullarton, “On the Regulation of Currencies,” pp.138-41; A. Wagner, “Beiträge zur Lehre von den Banken,” p. 126; J.S. Mill, “Principles of Political Economy,” Vol. II., Bk. II., pp. 204,210-11.

[80. ]Between November, 1925, and March, 1935, the monthlyfigures of the average percentage of cash to deposits held by theLondon Clearing Banks showed an absolute range of between amaximum of 12.0 percent and a minimum of 10.0 percent. Duringthe same period the Bank of England “proportion” showed a rangeof 65.5 to 11.5 percent, and, even ignoring these extremes,



fluctuations between 50 and 30 percent, or even 25 percent, maybe considered as quite a normal spread.

[81. ]“Geldwertstabilisierung und Konjunkturpolitik,” p. 61.

[82. ]See Hake and Wesslau, “Free Trade in Capital,” 1890; HenryMeulen, “Free Banking” (1st Edition, 1917, 2nd Edition, revised,1934).

[83. ]See the Chicago 100 percent Plan for Banking Reform, anaccount of which is given by A. G. Hart in an article entitled “TheChicago Plan” of Banking Reform in the Review of EconomicStudies, February, 1935.

